What is quantitative easing?

After months of speculation, last week America's central bank, the Federal Reserve, finally launched the next phase of quantitative easing (QE2). The Fed will pump another $600bn into the American economy between now and June. But how will it do this and, more importantly, what is it hoping to achieve?

What's the problem?

Quantitative easing is a grim term. But it actually describes the process fairly well. The aim is to ease financial gridlock in the US economy by throwing a huge quantity of money at the problem. In short, the Fed, like the Bank of England and Japan's central bank, wants to stimulate economic growth by creating new money and using it to buy assets.

The problem to be solved is actually quite simple. Since the credit crunch struck in 2007/2008, banks have been unwilling to lend and individuals and businesses have been unwilling to borrow and spend.

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One commonly used model says that economic growth is a product of the 'money supply' (the amount of cash and credit available) multiplied by the 'velocity of money' (how fast money changes hands between banks, firms and individuals). The problem is that once banks stop lending, velocity slows. So the Fed is trying to tackle this by increasing the other side of the equation the money supply to the tune of an extra $600bn.

Why do it?

This isn't the Fed's first attempt to bolster the economy. Prior to the crisis, the usual way to get banks lending and consumers spending was to cut interest rates. But that's been pushed about as far as it can go. Central bank rates are at record lows in many countries, including the US and Britain. But even with near-zero rates, banks have hoarded money because they're nervous of more loans going bad in the future. Meanwhile, firms have stopped investing because they're not sure if the economy is recovering yet. Individuals many afraid of losing their jobs are trying to restore their household finances and build up savings.

And the banks are guilty of more than just not lending. Able to borrow from central banks at such low rates, they have been reinvesting the money in safe assets, such as US Treasuries (US government debt).

A medium-term bond might offer a yield of, say, 2%. That's not great, but it's virtually risk-free. Other banks have clocked up sizeable profits by taking near-free money and speculating with it. It's no surprise that the prices of riskier assets, such as commodities, have been rocketing.

So the Fed has taken monetary policy to the next level. Enter QE. It has two stages. First, the central bank creates new money. Because it is the central bank it can do exactly that on a whim. It doesn't have to print $600bn in new notes, it just creates it electronically. Second, the new money is spent. Not on property, or goods, but on buying up bonds. During the first round of QE quite a bit of money was spent on buying up the troublesome mortgage-backed securities that were causing huge write-offs at many investment banks.

This time, however, the main target is US Treasuries. Here's the logic. By buying large numbers of these bonds, the Fed hope to crowd out the banks ('primary dealers' in the US). As the Fed buys, the theory is the price should rise. This in turn means the yield on the bond falls (this is known as 'yield compression'). As the yield falls, commercial banks will dump Treasuries and take the Fed's cash. The question is what they then do with it. The hope is that they will feel more confident to lend it out to firms. However, they may also simply hoard it, or even use it to speculate. That's the problem the Fed can't actually dictate how other banks use the money they receive. And that's not the only QE headache.

The potential costs

QE has never been tried before on the current scale, and no one knows for sure whether, and precisely how, it will work. The first round of QE had a specific purpose. Following the collapse, or near collapse, of several high-profile organisations, such as Lehmans and AIG, interbank (that's bank-to-bank) lending froze. Banks were so fearful that they wouldn't even lend to each other. You can argue that there might have been better ways to deal with the problem, but it's fair to say that the first batch of QE was certainly an emergency measure.

However, the purpose of this latest round is less obvious. The Fed hopes it will make the US economy grow more rapidly, but it could have some unpleasant side effects. First, it will put more downward pressure on the dollar. That's fine in so far as it makes US goods even cheaper for overseas buyers. But it also hits overseas investors, such as the Chinese, who hold large quantities of dollar-denominated assets. If the markets start to worry that America can't afford to reverse QE in the future, some fear an outright currency crisis. Then there's the inflation problem. If a commodities price-spike triggers rapid inflation hikes, bond yields will also rise sharply (the yields on longer-dated Treasuries have already jumped), which defeats the objective of QE and may push up US government borrowing costs. Little wonder investors have been piling into assets that can't simply be created at the click of a mouse such as gold.