Quantitative concepts

What Is Quantitative Easing?

Quantitative easing (QE) is an unconventional monetary policy tool used by a central bank to stimulate an economy by increasing the money supply and lowering long-term interest rates. It falls under the broad category of monetary policy. Typically, a central bank implements quantitative easing when standard monetary policy tools, such as adjusting the primary policy rate, become ineffective because interest rates are already near zero. Through large-scale asset purchases, primarily of government bonds and other financial assets like mortgage-backed securities, quantitative easing aims to inject liquidity into the financial system, encourage lending, and boost aggregate demand to combat deflation and foster economic growth.

History and Origin

The concept of quantitative easing gained prominence and widespread application following the 2008 global financial crisis, though the term itself was coined earlier by economist Richard Werner. Faced with a severe economic downturn and short-term interest rates already at the effective lower bound, central banks like the Federal Reserve in the United States and the Bank of England turned to this unconventional approach. The Federal Reserve, for instance, initiated its first round of quantitative easing in November 2008, purchasing mortgage-backed securities and agency debt to provide financial market stability and stimulate the economy. This policy was aimed at directly lowering long-term interest rates when conventional rate cuts were no longer possible. As former Fed Chairman Ben Bernanke famously quipped, quantitative easing "works in practice, but it doesn't work in theory," highlighting its pragmatic adoption in unprecedented economic conditions.⁶ The Bank of England similarly began its quantitative easing program in March 2009 to bolster the UK economy, purchasing government bonds to lower long-term interest rates and support spending.⁵

Key Takeaways

Quantitative easing is a monetary policy employed by central banks to inject liquidity and lower long-term interest rates when conventional tools are insufficient.
It involves large-scale purchases of financial assets, typically government bonds and mortgage-backed securities, from commercial banks.
The primary goals of quantitative easing include stimulating economic activity, preventing deflation, and supporting financial markets during crises.
While effective in stabilizing markets and lowering borrowing costs, the broader economic impact of quantitative easing can be complex and is subject to ongoing debate.
Central banks also manage the reversal of quantitative easing, known as quantitative tightening, to withdraw liquidity from the economy.

Interpreting Quantitative Easing

Quantitative easing is interpreted primarily as a signal of a central bank's commitment to aggressively support the economy and achieve its inflation targets. When a central bank engages in quantitative easing, it aims to lower long-term yields, which in turn reduces borrowing costs for businesses and consumers, thereby encouraging investment and spending. The sheer volume of asset purchases under quantitative easing can also lead to a "portfolio rebalancing" effect, where financial institutions, having sold their bonds to the central bank, reinvest the cash into riskier assets like stocks or corporate bonds, further stimulating market activity. The policy is often a response to a recession or a period of very low inflation, indicating that policymakers believe significant stimulus is needed to restore economic health.

Hypothetical Example

Imagine a country, "Economia," experiencing a severe economic downturn. Its central bank, the Bank of Economia, has already lowered its benchmark interest rate to 0.25%, the lowest it can go. Despite this, lending remains sluggish, businesses are hesitant to invest, and consumer spending is weak, pushing the economy toward deflation.

To provide further stimulus, the Bank of Economia announces a quantitative easing program. It commits to purchasing $500 billion worth of government bonds and agency mortgage-backed securities from commercial banks over the next year.

Here's how it might play out:

Bank Reserves Increase: The Bank of Economia credits the reserve accounts of commercial banks with $500 billion in exchange for the securities. This dramatically increases the banks' cash reserves.
Long-Term Rates Fall: With the Bank of Economia creating significant demand for bonds, bond prices rise, and their yields (interest rates) fall. This directly lowers long-term interest rates, making it cheaper for companies to borrow for expansion and for consumers to take out mortgages.
Lending Encouraged: Commercial banks, now flush with excess reserves, have more funds available to lend. While not guaranteed, the central bank hopes this increased liquidity will translate into more affordable loans for businesses and individuals, boosting overall economic activity.
Asset Prices Rise: As investors sell bonds to the central bank, they might use the proceeds to buy other assets like stocks or real estate, leading to a "wealth effect" that encourages more spending.

This hypothetical scenario illustrates how quantitative easing aims to provide a powerful monetary injection when traditional tools are exhausted, attempting to kickstart an economy from a deep slump.

Practical Applications

Quantitative easing has been applied by major central banks globally as a powerful tool in extraordinary economic circumstances. Its primary application is in managing the macroeconomy during periods of severe economic stress or when facing the "zero lower bound" on interest rates.

Crisis Management: Central banks, including the Federal Reserve, the Bank of England, and the European Central Bank, have extensively used quantitative easing to stabilize financial markets and support their economies during crises such as the 2008 global financial crisis and the COVID-19 pandemic.
Preventing Deflation: By increasing the money supply and encouraging spending, quantitative easing aims to prevent a damaging cycle of falling prices and reduced economic activity.
Lowering Long-Term Borrowing Costs: The purchase of long-dated bonds directly impacts the bond market, pushing down long-term yields, which in turn reduces the cost of borrowing for mortgages, corporate investments, and government debt.
Supporting Asset Markets: Quantitative easing can support equity and other asset prices by encouraging investors to shift from low-yield bonds to higher-yielding assets, potentially leading to a "wealth effect" that spurs consumption and investment.
Fiscal Benefits (Debated): While controversial, some analyses suggest that quantitative easing can have fiscal benefits for governments by lowering the cost of servicing public debt, effectively allowing for cheaper government borrowing. However, the implementation of QE has been criticized for sometimes focusing on "safe" government bonds rather than "risky" assets, which some argue limited its effectiveness and complicated exit strategies.⁴

Limitations and Criticisms

Despite its role in crisis response, quantitative easing is not without its limitations and criticisms. A significant concern revolves around its potential to exacerbate wealth inequality, as the asset price inflation it can induce disproportionately benefits those who own financial assets.³ Critics also argue that the effectiveness of quantitative easing in stimulating real economic activity, such as business investment and job creation, can be limited if commercial banks choose to hold onto the injected liquidity rather than lend it out.

Other drawbacks include:

Inflation Risk: While often used to combat deflation, excessive quantitative easing could theoretically lead to uncontrolled inflation if the economy recovers too quickly and the central bank fails to withdraw the liquidity in a timely manner.
Moral Hazard: Some argue that quantitative easing may create a moral hazard by encouraging excessive risk-taking by financial institutions, knowing that the central bank might step in during future crises.
Central Bank Independence: The blurring lines between monetary and fiscal policy during quantitative easing programs can raise questions about the long-term independence of central banks.
Exit Strategy Challenges: Reversing quantitative easing, known as quantitative tightening, involves selling off assets or allowing them to mature, which can be challenging to manage without disrupting financial markets or hindering economic recovery.² The macroeconomic impact and side effects of quantitative easing are topics of ongoing debate among economists.¹

Quantitative Easing vs. Quantitative Tightening

Quantitative easing (QE) and quantitative tightening (QT) represent opposite ends of a central bank's balance sheet policy. Quantitative easing is an expansionary monetary policy where the central bank purchases large quantities of financial assets, such as government bonds, to inject money into the economy and lower long-term interest rates. The goal of quantitative easing is to stimulate aggregate demand, combat deflation, and support economic growth, particularly when conventional interest rate tools are exhausted.

In contrast, quantitative tightening is a contractionary monetary policy where the central bank reduces the size of its balance sheet, typically by allowing previously purchased bonds to mature without reinvesting the proceeds, or by actively selling assets back into the market. The objective of quantitative tightening is to withdraw excess liquidity, raise long-term interest rates, and control inflation, often implemented when the economy is robust and inflation risks are rising. While quantitative easing expands the money supply and lowers rates, quantitative tightening contracts it and pushes rates higher, aiming to normalize monetary conditions after a period of exceptional stimulus.

FAQs

What assets does a central bank buy during quantitative easing?

During quantitative easing, a central bank typically buys government bonds (also known as sovereign debt or gilts) and other financial assets like mortgage-backed securities (MBS) from commercial banks and other financial institutions. The specific types and quantities of assets can vary depending on the central bank and the economic conditions.

How does quantitative easing affect interest rates?

Quantitative easing directly affects long-term interest rates by increasing demand for bonds. When a central bank buys bonds, bond prices go up, and their yields (which move inversely to prices) go down. This lowers the cost of borrowing for consumers and businesses, which in turn should encourage spending and investment.

Can quantitative easing lead to inflation?

Yes, quantitative easing can lead to inflation. By increasing the money supply and encouraging lending and spending, it creates more demand for goods and services. If the supply of goods and services cannot keep pace with this increased demand, prices may rise, leading to inflation. Central banks aim to manage the amount of quantitative easing to avoid excessive inflation.

Is quantitative easing the same as printing money?

While quantitative easing involves the creation of new money in the digital sense, it is not simply "printing money" and distributing it to the public. Instead, it's a process of electronically creating new central bank reserves to purchase existing financial assets from commercial banks. The intention is to inject liquidity into the financial system, not directly increase physical currency in circulation.

How does quantitative easing help the economy?

Quantitative easing helps the economy by lowering long-term borrowing costs for businesses and consumers, encouraging investment and spending. It also aims to boost asset prices, creating a "wealth effect" that makes people feel richer and more inclined to spend. The goal is to stimulate economic growth and prevent deflation when conventional monetary policy tools are no longer effective.