Skip to main content

Federal Reserve Chairman Ben Bernanke seems close to having the central bank engage in "Quantitative Easing." A lot of people may wonder what in the world that means.  Normally I post things more opinionated, but I thought this would be a good tutorial. For the benefit of everyone, I'm going to discuss what bonds are and the role of the Federal Reserve before getting to quantitative easing, or QE, as it's called.

What Are Bonds?

If you buy a US Treasury Bond the government is promising to pay you a fixed amount over a period of time, which can range from weeks to decades. Let's imagine you bought a 30-year bond for $100 that pays at 5%. This means you will get $5 per year from the government for 30 years. (There are bonds that protect against inflation but that gets more complicated). You have loaned the government money and they are paying you interest.

What's different about a bond from a normal loan is that the price of the bond can change, but your interest payment stays the same, in this case $5. The price of a bond is determined by supply and demand.  Say a lot of people wants to invest their money in bonds, so the demand increases.  You can sell your bond on the open market at say $120 instead of the original price $100.  But if I buy your bond, I still only get $5 per year, even though I had to pay more.  This means the rate of return on the bond (called the yield) will be about 4.17%   The price of the bond has gone up and the interest rate (yield) has gone down.  Likewise, if the price of a bond goes up, the interest rate (yield) goes down.  They are always in an opposite relationship.

Interest Rates

One major role of the Federal Reserve System (called the Fed for short) is to set interest rates on government bonds.  If interest rates on government bonds are really high, then people will rather keep their money in bonds than investing in the economy.  This may be good for individual portfolios, but it can slow down the economy.  So the Fed may reduce interest rates to give an incentive for businesses to invest that money rather than let it accumulate interest.  Likewise, if the economy is really booming and there are concerns about inflation (prices increasing), then the Fed may increase interest rates to give an incentive to buy bonds instead of investing money.

Quantitative Easing

At a basic level, the Fed controls the amount of money that circulates in the US economy. It does this through what are called Open Market Operations where it either buys or sells government bonds.  The Fed often does this, but Quantitative Easing (called QE for short) is when it is done on a larger scale in a major economic downturn.  For example, during QE the Fed is more likely to buy long-term bonds, while it usually only buys short-term ones.  What is most important is that during QE the Fed buys a huge number of government bonds from the public.  Banks own a huge amount of bonds, so after QE banks will now have money they can use instead of it being stored in a bond.  When the Fed buys a lots of bonds, the increased demand leads to an increased bond price, meaning interest rates (yields) decrease.  However, right now because of the poor state of the economy the Fed has already cut rates to close to 0%.  So by buying lots of bonds the Fed is not seeking to lower interest rates.  Rather it is effectively putting cash into the vaults of banks (it is all done electronically now of course), with the hope that since banks have more money on hand, they will be more willing to give out loans.  Those loans will lead to increased investments by businesses, which will hopefully get the economy going again.   Ideally, when the economy is in better shape the Fed will sell those bonds again, restoring a more normal money supply.

Republicans seem to enjoy trashing the Fed, such as Rick Perry's somewhat famous accusation of QE being treasonous.

In any case, I hope this is helpful for people.

Adam Weiss blogs at politicalcreativity.net

EMAIL TO A FRIEND X
Your Email has been sent.
You must add at least one tag to this diary before publishing it.

Add keywords that describe this diary. Separate multiple keywords with commas.
Tagging tips - Search For Tags - Browse For Tags

?

More Tagging tips:

A tag is a way to search for this diary. If someone is searching for "Barack Obama," is this a diary they'd be trying to find?

Use a person's full name, without any title. Senator Obama may become President Obama, and Michelle Obama might run for office.

If your diary covers an election or elected official, use election tags, which are generally the state abbreviation followed by the office. CA-01 is the first district House seat. CA-Sen covers both senate races. NY-GOV covers the New York governor's race.

Tags do not compound: that is, "education reform" is a completely different tag from "education". A tag like "reform" alone is probably not meaningful.

Consider if one or more of these tags fits your diary: Civil Rights, Community, Congress, Culture, Economy, Education, Elections, Energy, Environment, Health Care, International, Labor, Law, Media, Meta, National Security, Science, Transportation, or White House. If your diary is specific to a state, consider adding the state (California, Texas, etc). Keep in mind, though, that there are many wonderful and important diaries that don't fit in any of these tags. Don't worry if yours doesn't.

You can add a private note to this diary when hotlisting it:
Are you sure you want to remove this diary from your hotlist?
Are you sure you want to remove your recommendation? You can only recommend a diary once, so you will not be able to re-recommend it afterwards.
Rescue this diary, and add a note:
Are you sure you want to remove this diary from Rescue?
Choose where to republish this diary. The diary will be added to the queue for that group. Publish it from the queue to make it appear.

You must be a member of a group to use this feature.

Add a quick update to your diary without changing the diary itself:
Are you sure you want to remove this diary?
(The diary will be removed from the site and returned to your drafts for further editing.)
(The diary will be removed.)
Are you sure you want to save these changes to the published diary?

Comment Preferences

  •  The lesson we should take away from (4+ / 0-)
    Recommended by:
    Brian B, AdamWeiss, Noisy Democrat, UFOH1

    recent history is that while it is relatively easy to slow exchange and trade to a crawl by withdrawing money from circulation, putting it back does not speed it back up. That's because money isn't like the fuel for a gas engine, but the oil in the transmission. If you've got an oil leak or someone is draining the pan over night, the gears will eventually grind to a halt. Pouring in more oil even to the point of overflowing, won't restart the engine.

    Dividend income from bonds has been a "problem" for our investor class since about 2000.  First, it became apparent that the combination of the budget surplus generated by the tax increases under Clinton, together with the increased revenue for the Social Security Trust funds made it less necessary for the federal government to borrow, so the interest in bonds fell. 30 year Treasuries that were at 8.1% in 1991, were now going for less than 3%. So, Bush/Cheney came in determined to get rid of the surplus, so the bondholders would get a better return.  That ordinary folk whose nest eggs in CDs had been devalued, as well, should have worried them, but it didn't. Indeed, I don't think they gave much thought to the rules of thumb which affect the cost of money throughout the economy based on what the Treasury pays. If they had, they might have considered that retirees, who were used to getting 6% were very distressed to have that reduced to 2% and, as a result, prime targets for people offering them really risky investments to get them a 10% return.  Remember that ten years before, the base had been 8.1% for the most risk-free bonds.
    Anyway, since increasing the deficit didn't have the desired effect of making dividend rates go up, it was decided that it was China's fault for buying up our debt. But, what else were they to do with their extra cash?  The U.S. had pretty much stopped making anything for them to buy because our industries had been dismantled by the likes of Romney to convert assets into cash to hide in the Caymans. They killed the goose that laid the golden eggs.
    And now, like so many business failures, Romney wants a government job. 'Cause he's absolutely sure there's more to extract.

    Willard's forte = "catch 'n' cage". He's not into "catch and release."

    by hannah on Mon Aug 27, 2012 at 01:43:27 AM PDT

    •  Thank you for explaining some more pieces of the (0+ / 0-)

      picture. I'm little-by-little gaining an understanding of how bonds, CDs, interest rates, etc. work, and I appreciate comments that spell out a little more of the situation in terms that regular folks can follow.

      Please visit: http://www.jkmediasource.org

      by Noisy Democrat on Mon Aug 27, 2012 at 07:32:39 AM PDT

      [ Parent ]

  •  This was great (0+ / 0-)

    I've been trying to understand our financial system better, but I was confused by all the talk of bond yields going up and that being a bad thing. Now I get it. They mean that the price of the bonds is falling, which means that the bonds are currently seen as less desirable investments, but they're expressing it in terms of yields going up. Thank you! I wish you'd write some more like this, breaking pieces of our complex financial system down in simple terms. I've only recently come to realize how important it is for regular people to understand the economic "machinery" in which we live.

    One small correction to the article, though -- when you wrote "Likewise, if the price of a bond goes up, the interest rate (yield) goes down" I think you meant to reverse it -- "if the price of a bond goes down" -- because you had already talked about prices going up.

    Please visit: http://www.jkmediasource.org

    by Noisy Democrat on Mon Aug 27, 2012 at 07:30:43 AM PDT

    •  Thanks for the comment... (0+ / 0-)

      Sorry for the delay in replying.  I was away the past couple days and for some reason my smartphone wouldn't post comments on here.

      In any case, I'm glad the article was helpful and since you mention you'd like more writing like this, please feel free to give me an idea of something you'd like addressed and I'd be happy to write about it.

Subscribe or Donate to support Daily Kos.

Click here for the mobile view of the site