What is Quantitative Easing?
Quantitative easing, QE, or large-scale asset purchases, is an unconventional monetary policy resorted to by central banks when all conventional tools have failed to get an economy out of recession. Before jumping into QE, it might be a good idea to do a quick refresh of the conventional tools that central banks have at their disposal before they resort to QE.
Central banks are responsible for controlling the supply of money and the level of interest rates.
These two aspects of an economy are interrelated as one affects the other. An easy way to remember the relationship between money supply and interest rates is as follows.
Expanding the money supply leads to lower interest rates because there is more of it about, which leads banks to compete with each other to lend out their excess reserves by lowering interest rates.
When an economy is slowing or in contraction, central banks increase the supply of money, which lowers interest rates in order to reduce the cost of borrowing. This is in order to combat the effects of deflation, the worry is that prices will continue to fall as an economy continues to contract.
As explained above, when interest rates are low and banks hold excess reserves of cash, it is easier and cheaper to borrow, which encourages economic activity. This type of monetary policy is known as “easing”.
When an economy is growing, central banks tend to reduce the supply of money and raise interest rates. This is in order to combat the effects of inflation, the fear being that prices will begin to rise and erode the purchasing power of the national currency.
By removing liquidity from the system, central banks make money more scarce, which naturally causes banks to be more cautious about lending it out and raise their interest rates.
When interest rates are high and banks do not hold large excess reserves of cash, it is harder and costlier to borrow. This type of monetary policy is known as “tightening”.
Where does QE come?
QE has typically been reported to when an economy is still failing to grow after all the conventional tools come deployed to their limits. It is what we saw during the 2008 crisis, or “Great Recession” as it got called.
Interest rates had to get reduced to zero (below zero in some cases), and this was still failing to stimulate economic activity. In its normal operations, a central bank affects interest rates through the purchase of short term government bonds from the open market.
By doing this, the central bank increases the number of money banks hold on reserve, which leads to the dynamic described above where interest rates drop due to there being more money available in an economy for banks to lend out.
During the 2008 crisis, this was done across the board by central banks without the desired effect.
Economies continued to contract with their interest rates at or below zero. When interest rates are at 0, and this still fails to stimulate growth, it means that the central bank in question left with no (conventional) tools to deal with the crisis. Where Quantitative Easing comes in.
How does Quantitative Easing work?
Quantitative easing differs from the regular open market operations that central banks usually conduct (to keep interest rates at a target level).
As we have already seen, during a severe economic crisis, the interest rate has already reached zero (or lower), so there’s nothing more a central bank can do for the economy using interest rates as a tool.
When employing Quantitative Easing, central banks will purchase securities just as they do in their open market operations, the difference being that the quantities of these securities are much larger, and these purchases get made without reference to the interest rate.
Where the term quantitative easing comes from. It is an “easing” policy as described above, where the central bank purchases large quantities of assets to hopefully jump-start the economy by flooding it with liquidity.
Representing effectively money printing without using the printing press. The central bank creates money out of thin air and credits it digitally to the accounts of financial institutions it is trading. It then takes possession of the securities it is “buying.” During the Great Recession, these were principally government bonds and mortgage-backed securities.
What is the effect of Quantitative Easing?
A topic that is still hotly debated. The immediate effect is to massively increase liquidity in the economy while swelling the central bank’s balance sheet (how much it owes). In any other situation, such actions would be hugely inflationary.
As the value of the currency drops, goods, and services both within and without its borders become more expensive for everyone, individuals, and businesses. But since the economy is in such bad shape. Prices are also dropping as the economy contracts, so devaluing the currency isn’t considered such a concern.
Other effects of currency devaluation include making the country’s exports more competitive globally. International buyers of the country’s exports must first purchase the national currency to purchase its goods and services. A lower-valued currency makes these goods and services much more attractive internationally.
Another effect of quantitative easing is that it lowers the yield of the bonds it purchases by increasing its demand. Investors looking for return naturally have to look elsewhere, which stimulates other areas of the economy.
Additionally, in the case of corporate bonds, which central banks also purchase, lowering their yield by increasing demand, it effectively makes it cheaper for companies to take on debt and expand.
Has Quantitative Easing been a success?
The International Monetary fund has stated that the QE policies employed by central banks in the wake of the last crisis were effective in reducing the systemic risks facing the global financial system in the wake of the collapse of Lehman Brothers (which set the disaster in motion).
The IMF also claims that quantitative easing also helped the downturn to bottom-out by turn consumer and market confidence around.
Also, it should keep in mind that QE benefits those borrowing money rather than those saving as interest rates are so low. For the same reason, Quantitative Easing adversely affects pensions as the value locked up is effectively declining.
Furthermore, Quantitative Easing has been blamed for increasing inequality since the money printed is given to the banks first. Meaning that the benefit is felt first by banks, businesses, and high net worth individuals before it theoretically trickle down to the rest of the economy.
Capital flight is also a concern as banks are not obligated actually to lend out their excess reserves. Some may choose to hold onto them or invest this capital overseas, such as in emerging markets.
QE has been so controversial in its relatively brief history of use that even now. More than a decade on from the crisis. With QE once again getting discussed (and also implemented in a specific form in the case of the US repo market). Central banks are cautious to avoid calling what they are already doing or planning to do as QE.