July 11, 2013

Paul Rocha

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What is Quantitative Easing (QE) & How It Effects Your Mortgage

     There has been a lot of talk lately about Quantitative Easing aka QE and of course how the US Federal Reserve is considering easing its QE policy, resulting in an increase of about a 1% in the Canadian 5 year fixed mortgage rate. What is this infamous QE and how does it affect a Canadian mortgage, well let´s find out.

     The architect of this obscure thing we call QE is the US Federal Reserve aka "The Fed" or the US Central Bank . Among it´s other activities two of the major roles of Central Banks are inflation stability, and the stimulus of the economic engine. Central banks typically use interest rates and money supply to aid with these two activities, lowering rates to stimulate economic growth and thus increasing inflation, and conversely increasing interest rates to stifle economic activity, and thus decreasing inflation. In an effort to jump start the struggling US economy the Fed has lowered  interest rates to virtually 0% over the last several years. What´s worse for the Fed is that even with interest rates at near zero, the US economy is still very sluggish.This has resulted in the Fed running out of options to help stimulate the struggling US economy.

     The Feds answer to this dilemma has been to increase the money supply in the economy by adopting an unconventional monetary policy of buying financial assets from commercial banks, and other private institutions, as apposed to the more traditional policy of buying and selling government treasuries and bonds. So now instead of buying and selling their own safer bonds and treasuries, they are printing money to buy riskier commercial bonds. The intention of printing money to buy these commercial bonds should in theory stimulate the economy because the commercial banks now have more money in their coffers to allow them to start lending more (at least that´s the theory). In turn as lending becomes more readily available more and more corporation and private individuals start borrowing which should increase economic activity.

     Ultimately all market activity is governed by supply and demand. If we have high demand for something the higher the price tends to be. A good example is real estate the more people that are looking to buy (high demand) the higher the price of housing gets. Conversely the more supply there is for something the lower the price tends to be. Looking at our real estate example again, the more houses there are for sale, the lower the price of housing gets. So if the Fed is actively buying corporate bonds they  are artificially increasing the demand on the bonds and in turn raising their price and lowering their interest rate. Bond, price and interest rate are negatively correlated, meaning that when bond price increase the interest rate will decrease, and conversely if the price of the bond drops then interest rate increases). Think of it this way; imagine you bought a $1000 bond today that paid 10% interest, this means you would receive $100 of interest every year. Now imagine that tomorrow you were to buy this same bond but this time because there is so much more demand for it, you would have to pay $1100 for the same $100 of interest, this means that the percentage of interest you receive tomorrow is not 10% but 9.09% ($100 / $1100 = 9.09%)

     So there you have it QE simply means that the Central Bank (in this case the US Federal Reserve) is printing money (in this case $40 billion a month) to purchase commercial banks bonds, in the hope that this extra liquidity (extra money) that the banks have will lead them to start lending more and thus stimulate the economy.

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