Quantitative easing and its tapering off has been a much bandied about phrase. It is a strategy that has been adopted by the central banks of developed nations, including the Federal Reserve, Bank of England, and the Bank of Japan. It represents a strategy where the central bank purchases debt securities from institutional investors thereby leaving money in their hands. The debt that is acquired is primarily gilts or government securities, although some have also acquired securities issued by private entities. The anticipation is that this will stimulate demand for debt and equity securities and bring down interest rates.
Quantitative easing as a policy was largely a response to the financial crisis of the previous decade. The economy was facing the onset of a recession and inflation rates were undesirably low. There was a total lack on faith in the economic system, and people were unwilling to invest in financial assets issued by corporations.
Interest rate cut
The objective of quantitative easing is similar to an interest rate cut by a central bank, that is, to stimulate spending. When the central bank injects money into the economy, the sellers of gilts are likely to invest in other securities. This demand will push up the prices of these securities, thereby bringing down yields, for, in the case of debt securities, prices and yields are inversely related. If interest rates in the economy were to decline, it would bring down borrowing costs and stimulate investments. A related feature is that rising asset prices would mean an increase in wealth for investors. This too will be a stimulus for additional investments.
You may be familiar with another term called Open Market Operations or OMO. This refers to the purchase and sale of securities by the central bank of a country. In the US, the decision to undertake such operations is taken by an entity called the Federal Open Markets Committee. While there are similarities between quantitative easing and open market operations, there are major differences. In an open market operation the central bank primarily acquires short-dated securities from the market.
However, as part of quantitative easing central banks have also acquired medium term and long-term debt securities. Also, acquisition of privately issued securities may be a part of quantitative easing, a tactic that is absent in an open market operation. Finally, from the scale perspective, the two strategies differ considerably. Open market operations are undertaken on a much smaller scale.
To put things in perspective, in an easing strategy spanning a nine-month period in 2009-10, the Bank of England acquired about £200 billion worth of securities from the market. This represented about 15% of Britain’s GDP and constituted about 30% of the quantum of gilts held by the private sector.
Impact of quantitative easing tapering off
The tapering off of a quantitative easing policy refers to a strategy that will lead to higher interest rates in the country. If the Federal Reserve were to taper down its policy of acquiring gilts, it should lead to higher interest rates in the US. This will lead to a flow of capital into the country. This has implications for other countries like India which too are competing for scarce global capital, for funds which were earlier coming into India may be diverted to the US.
There are also related implications for the Rupee-Dollar exchange rate. As investors sell Indian securities to acquire dollars to make investments in the US, the dollar will appreciate and the rupee will depreciate. This will make imports more expensive for Indians and give a fillip to exports.
The author, Sunil K Parameswaran is a visiting faculty at various business school including the IIMs