How Quantitative Easing Can Lower Borrowing Rates
Summary
The document explains a proposed link between Federal Reserve bond purchases and lower borrowing rates. QE adds reserves to the financial system and can increase liquidity; at the same time, purchases can raise bond prices and reduce their yields. The answer connects these changes to the supply and demand for money, suggesting banks may lower lending rates to encourage borrowing as available funds increase. It also notes that greater liquidity can reduce banks’ own short-term borrowing costs, with interbank benchmarks such as LIBOR historically influencing some loans and contracts.
The explanation is a broad account rather than a detailed model or empirical analysis. It does not distinguish policy rates, bank funding costs, market yields, and loan rates, which may respond through different channels and need not move together. It also leaves out other factors that affect lending rates, including credit risk and monetary policy expectations. Its claim that banks lower rates to stimulate borrowing is presented as intuition, not demonstrated evidence.
Key ideas
- QE bond purchases can increase reserves and liquidity in the financial system.
- Bond purchases can raise bond prices and lower their yields.
- Greater liquidity may reduce banks’ short-term funding costs and influence lending rates.
- Benchmark rates can transmit market changes to loans and other contracts.
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Full text
# Why financial instistution for instance banks lowered down their interest rate during QE? # Why financial instistution for instance banks lowered down their interest rate during QE? When QE is carried out, the Federal Reserve prints money and buy government bonds in an effort to pour extra money into the economy. This causes financial institutions for instance banks to lowered their cost of borrowing. Why do these institutions decide to lowered down their interested rate just because they gain more money from the FED? From my reading, when the FED bought bonds, the price of the bonds become higher and the yield become less. How bonds yield and its price affect the interest rates of banks is what I don't understand? ## Answer by Neeraj (score 3) https://quant.stackexchange.com/a/22024 Put it simply, the interest rate depends on the forces of demand and supply of money. When the Fed buy bond, it increases the money supply into the economy. To induce the people to borrow more money bank reduces their own interest rate, otherwise, people won't have any incentives to borrow more. The interest rate is reduce to such level again equilibrium is reached in the market ( or demand gets equal to the supply). Further, increase liquidity in the market also reduces the cost of borrowing money in the money market. A good example is LIBOR (London Interbank Offered Rate). It not only reduces bank own borrowing cost but many loans and contracts are directly tied to LIBOR. Any change in LIBOR has direct impact on the trillions of contract tied to it. Similar to opposite happen when Fed reduces the money supply via selling bonds.
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