Quantitative Easing

Quantitative easing is a relatively new phenomenon, a word practically coined by Ben Bernanke to thwart off deflation.  While quantitative easing is a very simple idea to comprehend, it can have huge and unforeseen impacts on the financial markets. 

Quantitative Easing Explained

Quantitative easing is used by a central bank to increase the money supply to avoid the risk of deflation.  It has long been understand by Keynesian economists that a decrease in the general level of prices is what brings on economic recessions, as people struggle to pay off fixed denomination debts as wages and income decline.

Quantitative easing involves the “printing” of new currency and issuing it into the markets to devalue the per unit value of each individual paper currency unit and increase the general level of prices.  This is most often done at the bank reserve level, where a central bank exchanges newly printed bank reserves for other assets.

For instance, during the 2008 financial crisis and the months that followed, the Federal Reserve (the central bank of the United States) created a quantitative easing program of more than $1 trillion.  The Federal Reserve purchased assets from mortgage notes and debts to US Treasuries, and in exchange, it gave banks new money in their reserves.

In doing so, the Federal Reserve increased the supply of money by nearly 100% at the bank reserve ratio, creating the opportunity for further increases in the money supply and a devaluation of the dollar.  Since the program was first enacted, deflation risk has been removed, and the general level of prices has continued on a consistent incline, rather than decline. 

To sum it up in just one paragraph, quantitative easing requires creating monetary inflation that will then create price inflation on everything we buy.  The end goal is higher prices.

Making Money on Quantitative Easing

Ahead of quantitative easing, traders usually buy a few key investments that rise when inflation is at its highest.  Here are just a few:

Gold and other Commodities

Commodities almost always rise in times of increasing prices and inflation.  Since there are only a fixed amount of commodities, but an increasing supply of money chasing the same supply of commodities, the price rises. Gold and silver, which are considered to be monetary metals, rise the fastest in response to quantitative easing.  Oil is another good quantitative easing commodity play, since it is traded exclusively in US dollars.

US Treasuries

Quantitative easing is usually enacted by a central bank purchase of treasury bonds.  As a result, the buyers who can get into the market before the central bank begins its quantitative easing program should expect quick capital appreciation.

Foreign Currencies

The entire goal of quantitative easing (as described in quantitative easing explained) is to decrease the value of a local currency and increase the general level of prices.  As such, if the Bank of Japan were pursuing a quantitative easing program on the Japanese Yen, we would expect that without similar action from the Federal Reserve, the Japanese Yen would fall in value against the dollar.  Thus, an investor would be wise to initiate a long USDJPY position.

Get Used to Quantitative Easing

Quantitative easing is growing in popularity as a means to jumpstart an economy.  While it is particularly damaging to currency values, history suggests that deflationary policies are perhaps even more damaging, and quantitative easing may be best applied in extreme situations when the risk of economic depression emerges.
Tim Ord
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