What is Quantitative Easing (QE)?
- Real Vision
- June 7, 2022
- 6:01 PM
During tough economic times, people grow wary about losing their jobs and spending money. In such times, it’s the Central Bank’s job to keep the prices of things low and stable to help support people’s incomes and jobs. Rising prices cause inflation, and the U.S. government sets an inflation target for the Federal Reserve.
To keep inflation within the permissible target, the Fed changes the benchmark interest rate in the economy. Changes trickle down to how much interest you earn on savings and pay on loans. This affects the spending happening in the economy, hence helping inflation either rise or fall. But even when the benchmark interest rate is low, the Fed still has room to encourage spending and investment to boost the economy. This is where quantitative easing comes in.
Learn what quantitative easing is, how it works, how it affects inflation, and how it compares to printing money.
What Is Quantitative Easing?
Quantitative easing (QE) is a rather unconventional monetary policy implemented by central banks, like the Federal Reserve, in an attempt to boost the economy. The Federal Reserve buys a large number of long-term securities from member banks and the open market to boost the money supply and encourage investing and lending. After the influx, interest rates on savings and loans get lower, making borrowing easier.
Central banks conventionally lower short-term interest rates during weak economic times and raise rates when the economy is strong. The Fed may push short-term interest rates to or near zero, but the actions may not be effective in helping the economy recover. Instead, the Federal Reserve must explore other ways to expand the monetary base. In this case, it can target long-term securities like government bonds from pension funds. This raises bond prices, which lowers bond yields and interest rates in the economy.
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How Quantitative Easing Works
The Federal Reserve is in charge of the U.S.’s money supply — how money circulates in the economy. This implies that it can create money electronically, which is why QE is sometimes referred to as printing money though no new physical notes are created.
Quantitative easing is a large-scale asset purchase done by a central bank to place downward pressure on the market interest rates. Quantitative easing typically works in two ways. The first is through portfolio rebalancing, where the central bank alters the supply of assets that are available to investors. As investors sell government bonds to the Fed and replace them with riskier assets like real estate or stocks, their prices tend to rise, thus stimulating consumer spending and the economy.
The second way quantitative easing helps lower interest rates is by providing the signal that the Federal Reserve intends to keep policy rates low for an extended period. Ultimately, rising asset prices and falling mortgage rates help stimulate the economy just as conventional monetary policy would do.
The technical way that QE boosts the economy is if the Federal Reserve spends money to buy bonds, it’s essentially putting money into the economy. So, institutions that would have sold those assets to the central bank now have money to use for something else. Financial institutions may invest in a different type of asset that helps boost that specific asset market, while banks may lend the money out to consumers.
Quantitative easing slides money into the economy, thus triggering growth through increased money supply.
How Quantitative Easing Affects Different Markets
While quantitative easing primarily pushes interest rates down, it also affects multiple asset classes differently. Here’s how QE affects different financial markets.
Equities
Quantitative easing tends to favor the equities or stock market. Higher bond prices and lower bond yields mean lower returns and a less attractive investment. This encourages people to allocate their capital to equities. The increased weight toward stocks pushes stock prices higher and, subsequently stronger returns. Besides, companies could theoretically benefit from higher consumer spending, which may increase their likelihood of paying a dividend to shareholders.
Fixed income
Fixed-income assets, usually bonds, are often a direct culprit of quantitative easing. The large-scale purchase of bonds by the Fed pushes prices up but, in turn, reduces the yield on bonds.
Cash equivalents
Like bonds, cash equivalents like Certificates of Deposit (CDs) and Treasury bills are adversely affected by quantitative easing. The returns received by investors on their cash equivalents depend on the prevailing interest rates, which are reduced through quantitative easing.
Commodities
The global commodity markets are conventionally priced in U.S. dollars, and a large-scale asset purchase by the Fed could devalue the dollar due to a larger supply of money. This may have a positive impact on commodities priced in dollars.
Consequences of Quantitative Easing
The implementation of quantitative easing may not be universally beneficial to the economy at large. It also comes with some potential downsides as follows.
QE may cause inflation
Central banks primarily implement quantitative easing to encourage consumer spending in the economy. An increase in consumer demand and money supply could create the risk of inflation. The theoretical printing of money by the central bank could increase the supply of dollars. This may hypothetically reduce the purchasing power of the dollars already in circulation as people and businesses increase the demand for similar resources, hence driving prices to unstable levels.
Central banks also have a mandate to maintain inflation at specific permissible limits, so they may sometimes implement quantitative easing to increase inflation if it goes below the required target levels.
The most undesirable scenario for central banks is quantitative easing causing inflation without spurring the intended economic growth. The economic phenomenon where there’s inflation but no economic growth is known as stagflation.
QE may not trigger economic growth
Although central banks have the power to conduct regulatory oversight, they can’t force banking institutions to increase their lending activities. Similarly, they cannot force consumers to take out loans and invest. If the excess money supply triggered by quantitative easing doesn’t get into the economy, quantitative easing may not be effective in boosting economic growth.
Devaluing the domestic currency
Another negative consequence of QE is that it may cause the domestic currency to lose its value. A devalued currency could benefit domestic manufacturers since exports are cheaper on the global market. However, a devalued currency means that imports are more expensive, which may increase the cost of production.
History Implementation of Quantitative Easing
Different central banks have implemented quantitative easing differently and for various reasons. The theory behind QE is rather straightforward, and here’s how different central banks have used it.
The Federal Reserve
In response to the global financial crisis, the Federal Reserve initiated a series of quantitative easing in 2008. For instance, in November 2008, it purchased $600 billion worth of mortgage-backed securities to address the mortgage crisis. Between November 2010 and June 2011, the Fed purchased $600 billion in longer-dated treasuries.
The most recent implementation of quantitative easing was in response to the novel COVID-19 pandemic. Between March and July 2020, the Federal Reserve purchased $3 trillion in financial assets before initiating a bond-buying program in August 2020.
Bank of Japan
The Bank of Japan has been an ardent champion of quantitative easing, deploying its implementation for over a decade. Japan first used QE between 2001 and 2006. In March 2001, the Bank of Japan bought large amounts of government debt to boost liquidity in the banking system. In four years, the policy injected 30 trillion yen into commercial bank current account balances.
European Central Bank
In the wake of the European debt crisis, the European Central Bank started buying covered bonds in 2009 and sovereign bonds from member states between 2010 and 2011. Until 2015, the European Central Bank didn’t refer to these measures as quantitative easing. In January 2015, the ECB agreed to buy 60 billion in euro-area bonds. The purchases were increased to 80 billion in March 2016. Purchases ended in December 2018.
In March 2020, the European Central Bank announced the Pandemic Emergency Purchase Programme to reduce the cost of borrowing and increase lending following the COVID-19 pandemic.
Does Quantitative Easing Work?
For many economic experts, the answer is yes and no. Quantitative easing is effective at lowering interest rates and boosting the equities market. However, the policy’s broader effect on the economy isn’t as obvious. Also, the impacts of QE may benefit some more than others, say borrowers over savers.
Quantitative easing was extremely effective in the onset of the financial crisis and the coronavirus pandemic. Once markets stabilize, QE could trigger a bubble in asset prices, not forgetting the huge imbalance in income inequality.