Economic policy note

What Is Quantitative Easing?

Quantitative easing (QE) is an unconventional form of Monetary Policy implemented by a Central Bank to increase the money supply and stimulate economic activity. This policy typically involves the central bank purchasing large quantities of government bonds and other financial assets, such as Mortgage-Backed Securities, from commercial banks and other financial institutions in the open market. By doing so, the central bank aims to inject Liquidity into the financial system, lower long-term Interest Rates, and encourage lending and investment, especially when conventional monetary policy tools become ineffective, such as when interest rates are near zero.²⁸

History and Origin

The concept of quantitative easing first gained significant prominence in Japan. Following a period of economic stagnation and Deflation in the late 1990s and early 2000s, the Bank of Japan (BOJ) introduced quantitative easing in March 2001.²⁷,²⁶ Under this policy, the BOJ shifted its main operational target from short-term interest rates to increasing the current account balances (bank reserves) held by financial institutions at the BOJ, primarily through the purchase of Japanese Government Bonds.²⁵,²⁴ While the effectiveness of these early efforts has been debated, the Bank of Japan's early efforts paved the way for other central banks.²³

Quantitative easing became a widely adopted tool for major central banks globally in response to the 2007–2008 Financial Crisis., ²²The U.S. Federal Reserve, for instance, implemented multiple rounds of quantitative easing between 2008 and 2014 to combat the Great Recession and support Economic Growth. The policy was again utilized by central banks worldwide in response to the economic fallout from the COVID-19 pandemic in 2020.,
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20## Key Takeaways

• Quantitative easing (QE) is an unconventional monetary policy where a central bank purchases large-scale financial assets to increase the money supply and stimulate the economy.
• QE is typically implemented when short-term interest rates are already near zero, making conventional monetary policy ineffective.
• The primary goals of quantitative easing include lowering long-term interest rates, increasing bank liquidity, and encouraging lending and investment.
• QE was first extensively used by the Bank of Japan and later by the U.S. Federal Reserve and other major central banks during the 2008 financial crisis and the COVID-19 pandemic.
• The long-term effects of quantitative easing, particularly on Inflation and asset prices, remain subjects of ongoing debate among economists.

Formula and Calculation

Quantitative easing itself does not involve a specific mathematical formula in the way that, for example, a loan interest calculation would. Instead, it operates through the mechanics of a central bank's Balance Sheet. When a central bank implements quantitative easing, it creates new digital money (also referred to as expanding Bank Reserves) and uses it to purchase assets from commercial banks.

The core operation can be visualized as an exchange on the central bank's balance sheet:

• Assets Increase: The central bank's assets increase by the value of the securities purchased (e.g., government bonds, mortgage-backed securities).
• Liabilities Increase: The central bank's liabilities increase by an equal amount in the form of increased bank reserves held by commercial banks at the central bank.

This process directly increases the monetary base. The expansion of the central bank's balance sheet reflects the scale of quantitative easing. For instance, the Congressional Budget Office (CBO) analyzes how the Federal Reserve's quantitative easing programs affect the federal budget and the size and composition of the Fed's balance sheet.

¹⁹## Interpreting the Quantitative Easing

Quantitative easing is typically interpreted as a significant easing of monetary policy, aimed at providing an economic stimulus. When a central bank engages in quantitative easing, it signals its strong commitment to supporting economic activity. The goal is to lower long-term interest rates beyond what is achievable through adjustments to the short-term policy rate alone. This reduction in long-term rates makes borrowing cheaper for businesses and consumers, theoretically encouraging investment and spending.

The success of quantitative easing is often evaluated by observing its impact on various economic indicators, including long-term bond yields, bank lending, business investment, consumer spending, and ultimately, inflation and economic growth. For example, if bond yields fall significantly after a QE announcement, it suggests the policy is having its intended effect on interest rates. However, the direct link between the volume of asset purchases and real economic outcomes can be complex and influenced by other factors such as Fiscal Policy and global economic conditions.

¹⁸## Hypothetical Example

Imagine a country, "Economyville," is experiencing a severe economic downturn. Its central bank, the "Economyville Reserve," has already cut its benchmark interest rate to near zero, but economic growth remains sluggish, and businesses are hesitant to borrow and invest.

To provide further stimulus, the Economyville Reserve announces a quantitative easing program. It decides to purchase $500 billion worth of long-term government bonds and mortgage-backed securities from commercial banks over several months using Open Market Operations.

Here’s how it works:

1. Purchase: The Economyville Reserve buys the $500 billion in assets from commercial banks.
2. Payment: Instead of using existing money, the Reserve credits the commercial banks' reserve accounts at the central bank with newly created digital funds. The banks now have $500 billion in additional bank reserves.
3. Liquidity Injection: These increased reserves mean commercial banks have more liquidity. While they don't immediately lend out all these new reserves, the increased supply of funds in the banking system puts downward pressure on long-term interest rates.
4. Stimulus: With lower borrowing costs, businesses might find it more attractive to take out loans for expansion, and consumers might consider financing larger purchases like homes or cars. This increased lending and spending ideally stimulates demand, helping the economy recover.

This hypothetical scenario illustrates how quantitative easing aims to influence the economy when traditional interest rate tools are exhausted.

Practical Applications

Quantitative easing is primarily employed by central banks as a powerful tool within the realm of monetary policy, particularly in times of severe economic distress. Its practical applications span several key areas:

• Combating Recessions and Deflation: When an economy faces a deep recession and Interest Rates are at or near the zero lower bound, quantitative easing provides an additional mechanism to stimulate demand and prevent a deflationary spiral. Central banks purchase assets to lower long-term rates, encouraging borrowing and spending.,
• ¹⁷ Stabilizing Financial Markets: During periods of financial crisis, central banks can use quantitative easing to inject emergency liquidity into the banking system, stabilize asset prices, and restore confidence in financial markets. This helps ensure the continued flow of credit to households and businesses. The Federal Reserve's asset purchases during the 2008 financial crisis and the COVID-19 pandemic serve as prime examples.,
• ^{16 15} Influencing Long-Term Interest Rates: By purchasing long-duration assets like Government Bonds and Mortgage-Backed Securities, central banks directly influence their prices and yields. Increased demand from the central bank drives up asset prices and pushes down their corresponding yields, which in turn lowers long-term interest rates across the economy.,
• ^{14 13} Portfolio Rebalancing: Quantitative easing can prompt investors to rebalance their portfolios. When the central bank buys up certain assets, investors who sold those assets receive cash. They may then reinvest this cash into other assets, potentially including corporate bonds or equities, further stimulating financial markets and the real economy.,

#¹²#¹¹ Limitations and Criticisms

Despite its intended benefits, quantitative easing has faced various limitations and criticisms:

• Effectiveness at the Zero Lower Bound: While designed for when conventional policy is exhausted, some argue that the effectiveness of quantitative easing diminishes as asset purchases continue. Critics suggest that once long-term interest rates are already very low, further reductions may not significantly boost borrowing or investment, a concept sometimes referred to as "pushing on a string."
• ¹⁰ Inflationary Risks: A common concern is that the massive increase in the money supply through quantitative easing could lead to high Inflation. Whi⁹le many argue the newly created money often remains as Bank Reserves and does not directly translate into consumer spending, others contend that in certain conditions, it can fuel an increase in prices., Th⁸e⁷ post-pandemic surge in inflation has renewed this debate, with some commentators suggesting QE played a significant role.,
• ^{6 5} Asset Bubbles and Inequality: Quantitative easing can drive up the prices of financial assets, such as stocks and real estate, potentially creating asset bubbles., Th⁴i³s can benefit asset holders, often wealthier individuals, more than those without significant investments, potentially exacerbating wealth inequality.
• Exit Strategy Challenges: Unwinding quantitative easing, a process known as Quantitative Tightening, presents its own set of challenges. Central banks must carefully manage the reduction of their balance sheets to avoid disrupting financial markets or prematurely stifling economic growth. The² difficulty in quantifying the precise accommodation provided by QE makes it challenging for policymakers to judge the optimal pace and extent of unwinding.

##¹ Quantitative Easing vs. Quantitative Tightening

Quantitative easing (QE) and quantitative tightening (QT) are two opposing monetary policy strategies employed by central banks, primarily concerning the size and composition of their balance sheets.

While quantitative easing seeks to inject money and stimulate growth, Quantitative Tightening aims to withdraw that stimulus, often to control Inflation or prevent overheating of the economy. Central banks carefully manage the transition between these policies based on prevailing economic conditions and their policy objectives.

FAQs

Why do central banks use quantitative easing?

Central banks typically use quantitative easing when their primary tool, adjusting short-term Interest Rates, is no longer effective because rates are already near zero. QE provides additional economic stimulus by lowering long-term interest rates and increasing liquidity in the financial system, encouraging lending and investment during a Recession or period of low growth.

Does quantitative easing always lead to inflation?

Not necessarily. The relationship between quantitative easing and Inflation is complex and debated. While QE increases the money supply, the newly created money often sits as Bank Reserves in commercial banks rather than immediately circulating in the broader economy. Other factors, such as weak demand, high unemployment, or a global economic slowdown, can offset potential inflationary pressures.

What assets do central banks buy during quantitative easing?

During quantitative easing, central banks primarily purchase Government Bonds (like U.S. Treasury securities) and Mortgage-Backed Securities. The specific types and quantities of assets purchased can vary based on the central bank's objectives and the economic conditions.