What Is Quantitative Easing?
Quantitative easing (QE) is an unconventional form of monetary policy employed by a central bank to stimulate an economy, particularly when standard policy tools, such as lowering interest rates, are no longer effective because rates are already near zero. As a tool within the broader category of monetary policy, QE involves the central bank purchasing large quantities of financial assets, typically government bonds and other securities like mortgage-backed securities (MBS), from commercial banks and other financial institutions. The primary goal of quantitative easing is to inject liquidity into the financial system, increase the money supply, and encourage lending and investment, thereby supporting economic growth and preventing deflation28.
History and Origin
The concept of quantitative easing gained prominence and widespread application following the 2008 financial crisis. While some sources credit economist Richard Werner with coining the term in the early 2000s in reference to the Bank of Japan's actions, QE became a central pillar of post-crisis economic policy globally. After the 2007–2008 financial crisis pushed short-term interest rates to near zero, central banks, including the U.S. Federal Reserve, found themselves with limited conventional tools to combat a severe recession.
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In response, the Federal Reserve initiated its first quantitative easing program in late 2008. 26This involved large-scale asset purchases aimed at directly lowering long-term interest rates and stimulating the economy. 25The Fed's balance sheet expanded significantly through multiple rounds of QE between 2007 and 2017, and again in response to the COVID-19 pandemic. 23, 24Other major central banks, such as the Bank of England, the European Central Bank (ECB), and the Bank of Japan, also adopted quantitative easing to address economic downturns and fight deflation.
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Key Takeaways
- Quantitative easing is an unconventional monetary policy used by central banks to stimulate economic activity.
- It involves the large-scale purchase of government bonds and other financial assets from the open market.
- QE is typically implemented when benchmark interest rates are already near zero and traditional monetary policy tools are exhausted.
- The policy aims to increase the money supply, lower long-term yields, and encourage bank lending and investment.
- Major central banks globally, including the U.S. Federal Reserve, have utilized quantitative easing to combat economic crises.
Interpreting Quantitative Easing
Quantitative easing aims to influence the economy through several channels. By purchasing assets, the central bank directly increases their demand, which generally pushes up their prices and, conversely, lowers their effective yields. 20For instance, when the Federal Reserve buys long-term U.S. Treasury securities, investors who sold those Treasuries may rebalance their portfolios by investing the proceeds in other assets, such as corporate bonds, leading to lower yields across various asset classes. 19This reduction in borrowing costs for businesses can encourage increased capital investments.
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Furthermore, quantitative easing injects new reserves into the banking system, providing banks with more liquidity. While these reserves do not directly translate to money in the hands of individuals, the increased liquidity makes it easier and cheaper for commercial banks to extend loans to companies and households. This easing of financial conditions is intended to stimulate credit growth, consumption, and overall economic activity, helping to pull an economy out of a liquidity trap or a period of sluggish growth.
Hypothetical Example
Imagine a scenario where a country's central bank determines that economic activity is too slow, and its primary interest rate is already at 0.25%, with little room to decrease further. To stimulate the economy, the central bank announces a quantitative easing program.
It decides to purchase $500 billion worth of government bonds from commercial banks over six months. When the central bank buys these bonds from a bank, it credits the bank's reserves at the central bank with newly created digital money. The commercial bank, which previously held illiquid government bonds, now holds more liquid reserves.
With this increased liquidity, the commercial bank is in a better position to offer new loans to businesses and consumers. For instance, a business seeking to expand might find it easier and cheaper to borrow money. As businesses invest and consumers spend more, the expectation is that economic activity will pick up, leading to job creation and sustained growth.
Practical Applications
Quantitative easing has been applied as a significant monetary policy tool by several major central banks, particularly during periods of severe economic distress and low inflation. For example, following the 2008 financial crisis, central banks in the United States, the United Kingdom, the Eurozone, and Japan extensively used QE to counter recessionary pressures and avert deflation.
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In the U.S., the Federal Reserve embarked on multiple rounds of quantitative easing, purchasing billions of dollars in Treasury securities and mortgage-backed securities. 16These actions significantly increased the Fed's balance sheet, with assets growing from $882 billion in 2007 to over $4.473 trillion by 2017. 15The policy's goal was to lower long-term interest rates and foster conditions for greater private sector lending and investment. 14Researchers from the University of Chicago Booth School of Business have analyzed the effects of QE, finding that when the Fed buys government bonds, investors often buy corporate bonds instead, leading to lower interest rates and more investment.
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Beyond the 2008 crisis, quantitative easing was again deployed by central banks globally in response to the economic fallout from the COVID-19 pandemic. 12The use of QE in these critical moments highlights its role as a key instrument for central banks when conventional monetary policy reaches its limits. The Federal Reserve maintains information on its monetary policy tools, including large-scale asset purchases, on its official website.
11## Limitations and Criticisms
Despite its proponents, quantitative easing has faced several limitations and criticisms. One primary concern is the potential for inflation. Critics argue that by significantly increasing the money supply, QE could lead to a general rise in prices, eroding the purchasing power of currency. 10While proponents argue that banks act as intermediaries and do not directly place cash in the hands of individuals, the long-term inflationary pressures remain a debate point.
Another major criticism centers on the creation of "asset bubbles" and increased wealth inequality. By lowering yields on safe assets, QE might encourage investors to take on more risk, potentially leading to overvalued assets in markets like stocks and real estate. 9Critics also argue that this disproportionately benefits those who own financial assets, exacerbating wealth disparities.
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Furthermore, some economists suggest that quantitative easing may reduce the effectiveness of future monetary policy tools, leaving central banks with less "ammunition" to fight subsequent downturns if interest rates are already extremely low. 6There are also concerns about "moral hazard," particularly in Europe, where the purchase of government securities by central banks may artificially depress borrowing costs for governments, potentially reducing market discipline on fiscal spending. 5The long-term impact on bond markets and the "information content of the yield curve" are also frequently cited issues. 4While some criticisms compare the side effects of QE to conventional monetary policy, noting similarities, 3the debates persist regarding its overall efficacy and unintended consequences.
Quantitative Easing vs. Quantitative Tightening
Quantitative easing (Quantitative easing) and quantitative tightening are two opposite approaches within the realm of monetary policy, both affecting a central bank's balance sheet and the overall money supply.
Quantitative easing involves the expansion of a central bank's balance sheet through the purchase of government bonds and other securities. The aim of QE is to increase liquidity, lower long-term interest rates, and stimulate economic activity by encouraging lending and investment. It is typically implemented during periods of low inflation or recession when short-term rates are near zero.
Conversely, quantitative tightening (QT) involves the contraction of a central bank's balance sheet, usually by allowing previously purchased bonds to mature without reinvesting the proceeds, or by actively selling assets. The goal of QT is to reduce the money supply, raise long-term interest rates, and cool down an overheating economy to combat high inflation. While QE injects money into the financial system, QT withdraws it, effectively reversing the easing steps.
FAQs
Why do central banks use Quantitative Easing?
Central banks use quantitative easing primarily when their traditional tool of lowering interest rates is no longer effective because rates are already near zero. QE is deployed to inject additional liquidity into the financial system, stimulate lending and investment, and support economic growth during periods of economic slowdown or deflation.
Does Quantitative Easing lead to inflation?
The relationship between quantitative easing and inflation is a subject of debate among economists. Critics argue that by increasing the money supply, QE inherently carries the risk of leading to higher inflation. 2However, proponents suggest that banks act as intermediaries, and if the increased money supply leads to higher production, inflationary pressures might be mitigated. In practice, the inflationary impact of past QE programs has varied and is often difficult to isolate from other economic factors.
What types of assets do central banks buy during QE?
During quantitative easing, central banks typically purchase large quantities of government bonds and other fixed-income securities. 1In some cases, like in the United States, the Federal Reserve also purchased mortgage-backed securities (MBS) to support the housing market. The specific assets purchased can vary depending on the central bank and the economic conditions it aims to address.