What is Quantitative Easing?

If you have been following the fx market over the past few months, chances are that you have heard traders talk about the USD Federal Reserve's plans to "taper its QE" within the year. But what does the statement mean exactly? We shall fill you in in the following paragraphs, so read on.

What QE Means

QE stands for quantitative easing. This is something that a central bank does after its conventional monetary policy fails to stimulate the economy.

As you know, the economy of the United States has struggled since the beginning of the global financial crisis. In order to stimulate spending and improve its economy, the country’s Federal Reserve has introduced a number of interest rate cuts. It cut rates the last time in December 2008, which left the current rate at 0.25%.

But then the Fed could no longer bring the interest rate even lower. Thus, they were left with no other recourse than to inject money directly into the US economy. They did this through quantitative easing.

How QE Works

With a QE policy, the Fed (or any other central bank for that matter) buys government bonds from various private sector companies, such as banks and insurance companies. With their increased cashflow, these companies could then use the money for further investment or to lend to individuals. The Fed hopes that this would urge companies to lower their respective interest rates, and thus stimulate spending.

In a way, QE increases the money supply in the market. The Fed, however, will destroy the extra cash supply after they buy back the bonds they sold.

How QE Tapering will Affect the USD

Tapering became a buzzword when Federal Reserve Chairman Ben Bernanke said that the Fed may taper its QE within the year. This means the Fed will gradually slow down its QE policy.

The talk about QE tapering led to a stronger greenback. But why did it increase the US dollar’s value almost overnight? The reason for this is that when tapering happens, the supply for the USD becomes more limited, which then increases its value.

Tapering will not happen instantaneously. Rather, the Fed will take a gradual approach to this and make adjustments along the way as necessary. Doing this will help soften the impact on the private sector companies that received stimulus during the QE phase, as these will be negatively affected by the Fed’s move.