View FREE Lessons!
Definition of Credit Easing:
is a form of quantitative easing where a central bank increases the money supply by purchasing specific assets, with the intention of adding liquidity to the banking system and stimulating the economy.
Central banks use the buying and selling of government securities to influence benchmark rates such as the federal funds rate and LIBOR. (LIBOR is the London interbank offered rate and is an average rate that international banks charge when lending short-term funds to each other.) During recessions, central banks increase the money supply and lower lending rates to stimulate lending. But what happens when these rates fall to zero? Traditional monetary tools are no longer effective. The answer is to purchase assets…any financial asset…and create bank reserves (money) by depositing the amount paid for those assets in the seller's bank. This is precisely what the Federal Reserve and other central banks did following the Financial Crisis in 2008. Between December 2007 and early 2015 the Federal Reserve’s assets increased from $.89 trillion to over $4.5 trillion.
Adding liquidity to the banking system provides banks with the ability to accommodate an increase in withdrawals from concerned depositors without selling assets at a huge discount. It also provides lending institutions with the confidence to lend rather than hoard their cash. Unfortunately, during the 2008 financial crisis most of the increase in reserves were retained by banks as excess reserves because of more stringent underwriting.
Purchasing financial assets also lowers interest rates. The price of bonds and other interest-sensitive assets are not immune to the law of supply and demand. When the demand for a bond increases, its price also increases. A higher price results in the interest rate decreasing. For example, if the mortgage rate equals five percent, and the price of the mortgage equals 100, then the yield on the mortgage equals five percent. But if the price increases to 101, then the investor's yield decreases. (Watch the video Bonds
to learn how an increase in the price of a bond reduces its interest rate.)
What happens if lenders remain reluctant to lend? Normally, the central bank’s intention of adding reserves is to increase aggregate demand by providing the banking system an incentive for banks to lend to consumers and businesses. However, during the Great Recession, lending activity was less than the Federal Reserve wanted because many banks used their excess reserves to write down some of their nonperforming loans. Furthermore, many lenders tightened their underwriting requirements, and in doing so they approved fewer loans.
Loans are bought and sold, so when there is uncertainty about the quality of a loan, investors will either choose not to buy the loan, or demand a very low price. Credit easing is a type of quantitative easing that identifies specific interest-sensitive assets to purchase. Purchasing the assets adds liquidity and reduces interest rates. During the Great Recession there were doubts about the credit quality of many assets. Some sub-prime loans had been sold as investment grade investments when their real value was unknown. Discomfort with the credit ratings resulted in investors either discontinuing their investment in mortgage backed securities or paying a large discount because to the added risk. This widened the interest rate spread between Treasuries, and other debt to historically elevated levels.
Credit easing is a type of quantitative easing that identifies specific assets to purchase. Purchasing the assets adds liquidity and reduces interest rates. During the Great Recession there were doubts about the credit quality of many assets. After all, some sub-prime loans had been sold as investment grade investments. Discomfort with the credit ratings resulted in investors paying a premium for lower risk investments. This widened the interest rate spread between Treasuries, and other debt to historically elevated levels.
For example, the Fed invested over a trillion dollars in mortgage backed securities (MBS). On June 16th, 2016 the Federal Reserve owned over $1.7 trillion in MBS. As recently as December 2008, the Federal Reserve did not own any MBS. This enormous investment created an increase in demand for MBS which increased the price, lowered the interest rates of mortgages, while providing liquidity to the market. The Federal Reserve’s objective was to lower mortgage rates, thereby attracting home buyers and renewing confidence in the marketplace.
Another targeted asset was commercial paper. There was a growing concern that issuers of commercial paper would not be able to roll over the paper when it matured (i.e. pay it back by issuing more paper). The added investment risk added to the reissue rate. When the Federal Reserve purchased commercial paper, it added liquidity, while lowering the rate on commercial paper (since the demand increased). The European central bank used the same strategy to purchase corporate bonds.
Credit easing carries some risk, especially at the magnitude it was used between 2008 and 2014. One risk is losing money on the investments. Another is the inflation generated by increasing the money supply.
Dig Deeper With These Free Lessons:
Monetary Policy - The Power of an Interest Rate
Fiscal Policy - Managing an Economy by Taxing and Spending
Fractional Reserve Banking and The Creation of Money
Aggregate Supply and Demand - Macroeconomic Equilibrium
The Federal Budget and Managing the National Debt