What is Quantitative Easing?

Quantitative Easing (QE)

Quantitative easing (QE) is when a Central Bank buys long-term government bonds and assets from its member banks in order to inject money into the economy to expand economic activity. The Central Bank in return credits the banks’ reserves. The Central Bank’s main purpose is to maintain inflation at a target level and it can resort to different monetary policies which will help them achieve it. The injection of money into the economy leads to an increase in demand for the bonds which raise their price and lowers nominal interest rates in the market while simultaneously increasing the money supply. This leads businesses and people to borrow more, spend more and thus stimulate the economy.

QE is  particularly useful during times of financial crisis, when inflation is very low or negative, and standard expansionary monetary policy has become ineffective. This differs from the more usual policy of buying or selling short-term government bonds to keep interbank interest rates at a specified target value. Central Banks these days resort to QE because of the low short term interest rates which have a lower bound of zero. Thus buying  short-term government bonds to decrease short-term market interest rates does not work any more (due to a situation called liquidity trap). QE therefore helps Central Banks smooth out the path of inflation in the long run, helping them achieve their long term inflation target and signal the Central Bank’s future intentions about the stance of monetary policy to the public.

QE helps economies get out of recession and ensure that the inflation level does not fall below the target set by the Central Bank. Risks of such policies include, QE being more effective than estimated leading to an inflation above target or banks being reluctant to lend to borrowers in spite of the lower interest rate and high money supply in the market. 

 

Examples from the Past

The Bank of Japan (BOJ) adopted QE policies from March 2001 to March 2006 to fight domestic deflation in the early 2000s. They had maintained short-term interest rates at close to zero since 1999 but on 19 March 2001 the BOJ adopted the QE policy under which it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves and therefore little risk of a liquidity shortage. They accomplished this by buying more government bonds than would be required to set the interest rate to zero. It later also bought asset-backed securities and equities and extended the terms of its commercial paper-purchasing operation to increase the commercial bank current account balances from ¥5 trillion to ¥35 trillion (approximately US$300 billion) over a four-year period starting in March 2001. The BOJ also tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis. This QE policy helped Japan get back on its track for economic growth from 2002 to 2007 (before the financial crisis of 2008). 

The Financial Crisis of 2008 led Central Banks of the US, UK and eurozone to undertake policies similar to that of Japan. It took a few years for all the economies to get back on track after the financial crisis. In fact, after the 2008 financial crisis had ended, the International Monetary Fund (IMF) released a note where QE was discussed as an effective unconventional monetary policy.

The most recent use of QE was in response to the COVID-19 pandemic. On March 15, 2020, the Federal Reserve announced it would purchase $500 billion in U.S. Treasurys. It would also buy $200 billion in mortgage-backed securities over the next several months. On March 23, 2020, the Federal Open Market Committee (FOMC) expanded QE purchases to an unlimited amount. By May 18, its balance sheet had grown to $7 trillion. Fed Chair Jerome Powell said he was not concerned about the increase to the Fed’s balance sheet and inflation is not an issue as the Fed is able to hold onto any assets until they mature.

 

Pros and Cons

Pros:

 

• Lower Interest Rates –  The high money supply in the system leads to a fall in interest rates making loans more accessible to borrowers. Moreover, a lower interest rate helps to boost the economy in the short run.

• Prevents Unemployment – The availability of money as loans or as other forms helps improve the circulation of money in the economy. This in turn reduces the risk of rise in unemployment rates, especially during a financial crisis.

• Drains Toxic Assets – The purchase of subprime mortgages via QE helped in the removal of toxic assets present in the banks’ balance sheets. These assets would then be released slowly into the economy and get absorbed once the crisis was over.

• Immediate Results – The Fed announced the use of QE during the COVID-19 pandemic and its use has helped the US in many ways to prevent the economy from worsening.

 

 

Cons:

 

• Inflation – Quantitative easing may cause higher inflation than desired if the amount of easing required is overestimated and too much money is created by the purchase of liquid assets. Moreover, QE looks like a temporary fix as it is usually used in a depressed economy. A fall in interest rates increases the inflation rate only in the short run. In the long run, inflation rate falls leading to other problems in the economy.

• Business Cycles – Many critics believe that quantitative easing is the culprit behind creation of the business cycles. They believe that quantitative easing creates easy money in the economy. This money then reaches lenders who want to lend it out at any cost. They compete amongst themselves to find borrowers. In the process of this competition, they end up lending money to people who shouldn’t have received the loans in the first place. Therefore, the policy of quantitative easing first creates a boom i.e. an expansionary phase wherein the banks are lending money to everyone and when all businesses are growing. However, later the same monetary policy leads to deleveraging by the banks. This is because when quantitative easing stops, money becomes tight. This causes banks to call in their loans and as a result businesses start contracting i.e. a recession ensues. Therefore the same policy of quantitative easing caused both the boom as well the recession phase in the economy.

• Employment – Employment is closely linked with the business cycles. Thus an expansion and contraction in the economy leads to a rise and fall in the employment level.

• Asset Bubbles – Abundance of money always creates bubbles in the asset markets. Higher salaries and higher profits always find their way into these markets raising the prices of assets that are traded in them. Therefore the policy of quantitative easing leads to an asset bubble forming in the market. 

 

 

Conclusion

While QE has only been used for a couple of occasions, it is very difficult to predict the long term impact of it. In the short run, the QE mechanism handled by the Central Bank has stimulated various economies. The economists are still evaluating the cost and benefits of using QE to achieve their target inflation levels.