Quantitative Easing explained

QE Introduction

Quantitative Easing (QE) is an economic term that became very popular after the 2008 financial crisis. It was widely used by the U.S. Federal Reserve (Fed), and a few years later by the European Central Bank (ECB), who launched a very popular QE program in March 2015, known as Draghi Plan.

The QE is a non-conventional instrument for monetary policies normally adopted when ordinary monetary policies fail. In a very simple way, QE happens when Central Banks purchase public debt (bonds) to encourage lending of money, increasing the money supply that stimulates private investments, thus, acting as an expansionary and stimulator program.

What is striking about the QE is the high amount of these purchases. Although Japan was the first country to use this instrument from 2001 to 2006, the U.S. Federal Reserve attempted the best QE exertion. It added nearly $2 trillion to the cash supply. It is important to emphasize that the obligation on the Fed's monetary record multiplied from $2.106 trillion in November 2008 to $4.486 trillion in October 2014, becoming the main investor/buyer of US Treasury bonds. As mentioned before, the European Central Bank embraced QE in 2015, but later on, a deep analysis will be explored 

Until now, Central Banks have been focused mainly on the purchase of public debt. However, there have also been programs to purchase other assets secured by mortgage loans. The purpose to buy these assets was straightforward. On the one hand, by increasing the demand for these assets, their price rises and profitability falls, thereby reducing the cost of financing the State. On the other hand, by increasing the price of public debt, it makes other assets that are at risks, such as stocks or company debt, relatively cheaper, and therefore more attractive.

In a theoretical way, the positive effects on real economy are that savers can invest in bonds issued by private companies, which are much more profitable. In this way, the financing of these private companies is facilitated in less expensive terms. In some cases, these programs have effects on the value of the currency of the country carrying out the measurements. The currency of these countries begins to be worthless in the foreign exchange market, due to the effect of QE and that favors their exports, which become more competitive.

It is important to note that this is theoretical, and not all the effects are positive. QE can lead to price increases, especially when the currency depreciates, as all imported goods are more expensive. Higher prices reduce the purchasing power of families and companies and may reduce the positive effect of the program since investors could demand a higher return to cover that inflation risk.

Quantitative Easing: Basic Process

The QE program began in Europe when Mr. Mario Draghi, president of the ECB from 2011 to 2019, announced in July 2012:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” After that statement markets were waiting to see what the meaning was of whatever it takes and enough.

While this press conference was taking place, the EU's structure was beginning to crack worryingly. Greece, Ireland and Portugal have already been bailed out, the Spanish banking system has been rescued, and Italy, the euro zone’s third-largest economy, had 2 trillion euros in debt. Fear had permeated in such a way that this infernal loop with three concatenated problems seemed unsolvable. Precisely, the possibility of default on debt in some countries, uncertainty about the solvency of banks, and the system's circulatory system. This led to economic stagnation in the whole eurozone. Mr. Mario Draghi's words were a balm for markets and generated high expectations.

10-year government bond yields (%)

Notes: 1) “Whatever it takes’’; 2) QE announcement; 3) Start of QE; 4) New plan and expansion of QE.

 The ECB's objective is to maintain price stability by controlling inflation below , but close to 2%, thus indirectly, they are ensuring a good economic performance. When economic growth is in jeopardy, and inflation falls below its target, the ECB acts by lowering interest rates. This allows banks to offer loans at a lower interest rate and thus stimulate economic growth. But when these kinds of measures are not enough because interest rates are at very low levels, the ECB must use other strategies.

It was in January 2015 when the ECB announced a program of massive purchases of public debt as part of its non-standard monetary policy measures.

The plan’s details included:

• €60 billion per month, between March 2015 and September 2016. In total, for 19 months, the plan has a budget of 1.14 trillion euros.
• To purchase sovereign bonds from euro-area governments and debt securities from European institutions and national agencies.
• All the Eurozone countries, except Greece which was under a bail-out program, would participate.
• Acquisitions will be made in the secondary market, where investors of all kinds buy and sell titles already issued by the National Banks.
• A condition: this instrument will remain beyond if inflation continues to be low and doesn’t come close to the ECB’s target of 2% in the midterm.

The initial plan changed several times since its birth:

• In December 2015, the ECB declared an extension of the QE, until at least March 2017, and cut the interest rate.
• In April 2016, increased upon 80 billion euro and announced
• In December 2016, extended nine more months (from March 2017 to December 2017), and the injections decreased again to 60 billion euro in April 2017.

Draghi’s plan was active since December 2018, when the ECB definitively stopped the bond purchases. Under QE, the ECB’s balance sheet has ballooned to about 4.65 trillion euros. It took almost 3 years to start with the QE plan. A lot of time, to define arrangements and, even more important, reach a solid agreement between the members.

Germany was tough. Chancellor Angela Merkel, her Finance Minister, and the Bundesbank President were all highly critical & against the ECB’s bond purchase program. Their monetary orthodoxy, their legal technicalities, and their appeal to ethics were their three main arguments. In their opinion, each country must assume their own responsibilities. This precept is what the German Government has also been able to impose through the articulation of the banking union, with the configuration of the controversial "cascade of responsibility" of bailouts to financial entities, whose latest ranking is third-party taxpayers’ countries. Also, Germany has maintained that the purchase of bonds by the ECB was not its responsibility, which it interpreted restrictively as disguised state financing, instead of focusing on price stability and the risk of high inflation.

They pointed out that a combination of inflation, which detracts from debts, and improved external competitiveness, via the depreciation of the euro, could discourage the implementation of structural reforms in countries in crisis due to the "artificial" improvement in the economy. This is because QE can’t be used to replace fiscal policy. In other words, if the QE doesn’t push banks to use the created money, there is a necessity for the government to be more proactive in stimulating demand. In the end, as a concession to the so-called guardians of orthodoxy, only 20% of the risks will be shared (owned by ECB), the remaining 80% will fall on each National Central Bank. 

Pros of QE

Analyzing the effects of QE is a difficult task, because effects, in Economy, can be totally different in a matter of time. 

Thinking in the short term, it could lead to a boost in the economy as markets celebrate the increased money supply and low interest rates. In fact, with the announcement of the Draghi Plan in January 2015, that was the reaction achieved: a sharp reduction in the interest on the debt and a depreciation of the euro. During the months following this implementation, the ECB measures generated a substantial improvement in the stock markets, as well as a rise in the price and a fall in the yield on sovereign and corporate bonds. But, how did the QE affect the EU?

Economic effects

• GDP 

Since entering a downturn in 2012 (-0.9), the euro zone has gradually recuperated, astonishing markets with an especially solid exhibition in 2017 (2.4)

Real GDP growth, 2008-2018

• Loaning

Over almost four years, the ECB has worked to discourage getting expenses and increase loaning. While this has generally paid off, the development in loaning has relaxed, showing that the cycle has reached its maximum level.

Market effects

• The €

Having tumbled after the QE dispatch, the euro has ascended on an exchange weighted premise since 2016 because of a more grounded economy. The measure supposes an injection of liquidity in the market, which devalues the price of the euro. This makes European exports cheaper and more competitive, which should help the recovery of the economy. In the end, with the stimulation of internal and external consumption, the ECB combats the risk of deflation.

• Government bond yields.

The QE has maybe been felt most intensely in security markets. Government borrowing costs in Spain, Portugal and Italy hit record lows after the implementation.

Note. D line > Mr. Mario Draghi pronounced “whatever it takes”.

Summing up, the QE could be classified as an experiment of the ECB to boost the economy after a period of crisis. These last years have been unique in history, as an unconventional program, of such dimensions has never been implemented before. For this reason, uncertainty has managed in the markets during these last 10 years. The QE has been highly controversial, both since its launch and its completion. However, since the current situation cannot be compared to past events to see their effects, it can be affirmed that the ECB knew how to act and transmit assurance to the markets in view of the indicators shown. It can be acknowledged that there are benefits to the ECB’s quantitative easing. However, it cannot be ignored that there are many weaknesses in the program, and criticisms from both inside and outside the eurozone. 

Cons of QE

The first, and most obvious consequence, is that QE, which intended to raise inflation, interest rates in the long-run, and strengthen the euro zone, has brought little change in the short-run and potentially kept rates low in the long-run. The QE had a massive barrier to overcome in raising the inflation from nearly 0% to 2% in just four years. While the ECB hoped, and hypothesized, that this could be possible, absolutely it was not guaranteed to be a success. To raise inflation by 2% would take an incredibly powerful set of measures to create this achievement. While the QE is a very powerful tool, it is not sufficient on its own. The first three months of 2019 showed inflation expansion at only 1.2%, and more recent data are revealing that a slowdown could be coming. This is argued amongst statisticians, economists, and even the Eurostat, with some projecting slow but improved growth, and other predicting stagnation. As seen from the graph, the US Federal Reserve has been steadily increasing the rates, while the ECB has kept them at a record low through 2019.

For how long can the European Central Bank continue the QE within the eurozone? The QE increased the total purchases of bonds from 60b euro monthly in 2015 to 80b euro in 2016. In 2017 Draghi announced he would ease out the QE and reduce the purchases to 30b euro, with the program ending in 2018. Then, at the end of 2019, it was announced that the QE would be implemented once again at 20b euro monthly. Is this a sustainable option? Reuters reported that

“The ECB has spent 2.6 trillion euros ($3 trillion) over almost four years, buying up mostly government but also corporate debt, asset-backed securities and covered bonds.”

As long as the ECB continues to increase the amount of euros spent buying mostly government debt, governments are not held accountable and there is a dependency in the economy for the ECB to continue this program. The Financial Times likened the QE to a placebo for the eurozone, reassuring investors while failing to make any true impact in the economy, The head of macro research for BNP Paribas Asset Management summed it up by saying,

"The bond market is adamant it needs stimulus, but equally adamant it doesn’t work."

Confliction Between Monetary and Fiscal Policy

A further consequence in the QE program is the lack of combination in monetary and fiscal policy. The ECB pushed more and more measures into the eurozone without demanding that member state governments create fiscal policy changes. Bloomberg explained this tension, “EU fiscal policy remains very conservative, meaning little bond issuance. In other words, European monetary policy is reaching the point where it is limited by fiscal policy. It needs governments to borrow more before it can become truly expansive.” 

Without the counterpart of an agreement by member states to change their fiscal policy and begin reinvesting, the QE will remain largely ineffective at reaching its target. While one of the goals was to attract foreign investors once again, the need for investment in public and private banks and investments within the EU is crucial. However, the data shows there has not been an investment of private banks into the private sector as hoped for. The majority of change in sovereign bond holders between Q4 2015 and Q2 2018 have not been counteracted by resident banks, but mostly by non-resident sellers, with the exception of Spain. This is a serious issue for the ECB as they hold member state bonds and assets on their balance sheet, but notable increase in investment is coming from non-government, non-resident banks and institutions.

German economists and the Bundesbank shared this concern about a lack of fiscal policy measures to ensure there is a true effect in the nearly 3trillion euro investment of QE. It’s generally the consensus that the QE has been used by the most countries within the eurozone to “keep the interest rate low and to simulate the economy from the monetary side rather than the fiscal side.” But constant stimulation is not stability or growth, and this circles back to the placebo effect the QE is creating in the economy. The Wall Street Journal reported on the Bundesbank president’s stance on QE,

The Bundesbank president underlined concerns that sovereign-bond purchases by the ECB would undercut reform efforts in Europe. “I am worried that sovereign-bond purchases will undermine structural reforms and budget consolidation in euro-area countries, especially if the impression were to emerge that the central bank is stepping in to take the place of effective policy action time and again,” he said.

The habitual course the ECB has taken to step in and “save” the eurozone over and over again without the necessity of accountability and intervention from member states’ governments and banks is undermining structural reforms, as Mr. Weidmann stated. One of the greatest weaknesses in quantitative easing is the lack of fiscal policy to create stabilization. Stefan Gerlack, the Chief Economist at EFG bank in Zurich and a former deputy governor of the Central Bank of Ireland, gave his opinion in a comprehensive review of the QE. His final thoughts were thus,

“Although headline inflation rose, underlying inflation remains weak, meaning that the ECB must maintain an expansionary monetary policy.”

Questioning 2% Inflation

Secondly, another major weakness is that the rationale behind the QE is based on the theory that inflation should be at 2%. Why did the European Central bank decide that two is the magical market rate for inflation across the eurozone? Well the history predates even the creation of the European Union. In the mid-1990s in the United States, a few Federal Reserve policymakers agreed that the target for inflation should be 2%. In 2012, the Chairman of the Federal Reserve, Ben Bernanke, made it public and ushered the approval for the policy to be instituted. The ECB and other institutions quickly adopted this policy as well. What was Bernanke’s justification for the 2% inflation? Why not 0% inflation? This was his response to that question during a senate hearing in 2012,

“So historically, the argument for having inflation greater than zero–we define price stability as 2 percent inflation as do most central banks around the world. And one might ask, “Well, price stability should be zero inflation. Why do you choose 2 percent instead of zero?” And the answer to the question you’re raising is that if you have zero inflation, you’re very close to the deflation zone and nominal interest rates will be so low that it would be very difficult to respond fully to recessions. And so historical experiences suggested that 2 percent is an appropriate balance between the cost of inflation and the cost that you’re referring to. We haven’t contemplated changing that. We just put that number in as, you know, fairly recently. I think at this point, it’s still being debated in academic circles that–you know, and we’ll see what kind of outcome they come up with. But it’s an interesting question to try to quantify. There is research, for example, which asks the question how often do you tend to hit the zero lower bound? And our belief a few years ago was that it was a very rare event and now it has become more common.”

Essentially, the 2% inflation rate was a hypothetical solution to be tested and changed over time as the markets grew, shrunk, or stagnated. However, the hypothesis was accepted as the foundation of monetary policy measures and not altered. Certainly it could lead to many consequences for the ECB if they discover in the following years that a 2% inflation target was the wrong number to gamble on for their aim of nearly 3billion euro in quantitative easing. The inflation rate should be based on the European market, not the American. There are a few key differences in how the USA and the eurozone calculate inflation which could even further prove the foundational fracture of the “2% rule.”

For example, the euro area core inflation does not account for highly volatile items such as food or energy, whereas calculations for the USA do include them. Energy prices have the potential to make a massive economic impact, as we’ve seen from the recent stock exchange decline. If the ECB basing its model of monetary policy and economic security on a 2% inflation rate which is measured differently than the USA, who theorized the importance of that rate, there can be major holes in the effectiveness of eurozone policies and measures. A statistician for Bruegel used Eurostat data to create a graph which compares inflation according to the standard calculations for the EU (core inflation) and one which based on the USA model which includes energy.

The core inflation including energy was actually lower for since 2010 than was originally thought; this makes a 2% rate even more unattainable whereas the USA was closer to 2% for the majority of time after 2010. For a program so extreme as the QE, which has spent roughly 7,600 euros for every person in the euro area, this type of unproven theory of necessity of inflation is a major weakness. An investment in people’s lives through a raise in wages, lowering of government deficits, and stricter financial budgeting and policies are a few ways that the ECB could have partnered with member states to invest nearly 8,000 euro per person, not on a theory created by the USA federal reserve 25 years ago.

Exogenous Shocks

Lastly, the QE puts the ECB in a position of weakness for any large scale exogenous shocks that could happen. The ECB may be dealing with this weakness very shortly, as the coronavirus will certainly have a large short-term impact on the economy, but potential impacts in the long-term as well. On Monday, March 9, 2020, stock markets fell across Europe with 8% losses in Spain, Germany and France. One newspaper reported that “Black Monday” as some are calling it, “outstripped the depths of the eurozone sovereign debt crisis… the biggest sell-off came in Italy, with stocks in Milan collapsing by more than 11%... Global stock markets posted their steepest falls since the 2008 financial crisis on Monday after a crash in the oil price amplified concerns about the escalating economic cost of the coronavirus outbreak.” 

With the ECB already paying billions every month for quantitative easing, how much more can they possibly spend on an economic stimulus package or for tax deductions/credits/incentives the following years to help small businesses and/or individuals? Even still, these types of measures will continue the cycle of member state dependency upon the central bank while not bringing needed fiscal policy change at a national level.

Alternatives, the Asset Purchase Program

Under regular economic circumstances, the ECB regulates wider financial markets and macroeconomic trends and inflation, primarily through the establishment of key short-term interest rates. Yet the key interest rates have stayed close to their effective lower level as a consequence of the global economic crisis; the level at which a reduction will have little to no implications.

Consequently, the ECB used non-standard measures to deal with the possibility of a period of low inflation that lasted for too long and to lift inflation to approximately 2% below medium-term thresholds, which is the concept of price stability by the Governing Council. One of the ECB's non-standard measures, for this reason, is the Asset Purchase System.

The ECB's Asset Purchase Program (APP) forms part of a package of non-standard monetary policy initiatives, which also contains coordinated long-term refinancing measures. It was introduced in mid-2014 to strengthen the process for monetary policy transmission and provide the requisite support to preserve price stability.

How does APP works

The ECB acquired a range of assets ranging from €15 to €80 billion per month under the APP, including government bonds, securities issued by the supranational institutions, covered bonds, bonds backed up by assets, and corporate bonds. These buying activities impact broader financial conditions and, ultimately, economic growth and inflation through these main channels:

Direct transfer

The increased demand for these commodities, as the ECB buys private sector assets (like asset-backed securities and covered bonds, which are related to loans issued by banks to companies and households in the Real Economy) increases prices. This allows banks to make more loans and then to produce and sell more covered bonds or asset-backed securities. The rising supply of loans continues to reduce bank lending costs for companies and families, thus enhancing broader funding conditions.

Portfolio rebalancing

The ECB has acquired private and public assets from pension funds, banks and households. These lenders may opt to take the funds they obtain from the ECB and spend them in other funds for assets. This portfolio-rebalancing process pushes prices up and yields down by increasing demand for assets more generally, even for properties which do not directly benefit from the APP. As a result, interest rates are reduced for businesses pursuing capital markets funding. The increase in bank lending to the real economy continues to cut households and corporations ' borrowing costs. When creditors, on the other hand, use the extra funds to buy higher-returned assets outside the eurozone, this may also boost inflation.

Both the direct transfer and re-balancing channel portfolio hopefully boost wider financial conditions for euro-area companies and households. Through reducing the cost of financing, asset acquisitions will raise investment and consumption.

Signalling effect

Finally, the asset purchase signals the market that, for a long period of time, the central bank can retain low key interest rates. This signaling effect decreases market uncertainty and volatility with respect to potential changes in interest rates. This is critical as it directs various decisions on investments. For example, long-term lending interest rates should stay lower as banks expect a long period of low interest rates. The ECB's asset purchase program reassures investors that inflation will be just below 2% in the medium-term, a requirement for sustainable growth in a price stability context.

How APP is composed

APP is composed by:

• corporate sector purchase programme (CSPP)
• public sector purchase programme (PSPP)
• asset-backed securities purchase programme (ABSPP)
• third covered bond purchase programme (CBPP3)

Furthermore, reinvestments of main payments from the maturing assets acquired under the APP shall remain entirely in place for a longer period after the beginning of the increase of the main ECB interest rates by the governing council. And, in all cases, it remains for all the time required for the preservation of fair terms of liquidity and a wide range of monetary accommodations.

Eurosystem holdings under the APP

APP cumulative net purchases, by programme

APP Recovery

Through seamless and dynamic execution, the Eurosystem adheres to the concept of market neutrality. In order to maintain a stable and healthy market position, the Governing Council has agreed to spread the reinvestment of principal redemptions over time.

Conclusions

While executing QE, the central bank buys long-term public debt from mutual funds. The purchases are financed by the issuance of reserves which activate deposits for intermediary banks. Such deposits are not kept by mutual funds because they have low returns. The deposits are therefore carried by households, who support liquidity, to ensure their smooth use if they are unemployed. At the same time, when executing QE, we face several economic, social and political implications.

Macroeconomic implications

DM > 0 shifts the LM curve down, causing the interest rate to fall… 

Because MP=kY-hr then r=kYh-MP

… which increases investment, causing output (Y) & income (W) to rise.

… increase in GDP, by keeping Prices constant, increases Aggregate Demand

It should be considered that, during quantitative easing, the sensitivity of money demand in respect of the interest rate (h) tends to zero, thus the LM curve can be considered vertical, for the quantitative theory of money.

A change in monetary policy shifts the LM curve and we see a movement along the IS curve which will ONLY change the interest rate, not real GDP. This means monetary policy is ineffective at increasing or decreasing real GDP.

Can QE permanently replace conventional monetary policies? This is ambiguous, as welfare depends not only on production fluctuations and inflation in heterogeneous economies, but also on inequality. Effective QE has significant side effects which contribute to inequality. QE interference results in variations in the aggregate supply of deposits that contribute to time changes in the manner in which families can offset variations in income (velocity of money). Corporate income volatility triggered by QE may also redistribute capital. While the intake of households under QE policy also swings tremendously, reducing social welfare. Hence, in our social welfare system, welfare is lower with QE than in traditional optimal monetary policies. Such side-effects suggest, given their success in stabilizing macroeconomic volatility, QE is second best to traditional monetary policy.