Quantitative easing

What Is Quantitative Easing?

Quantitative easing (QE) is an unconventional monetary policy tool employed by central banks to stimulate an economy, typically when conventional monetary policy measures, such as lowering interest rates to near zero, have become ineffective. It involves the central bank purchasing a predetermined quantity of long-term financial assets, such as government bonds and other securities, directly from commercial financial institutions. This action injects new money into the financial system, increasing the money supply and aiming to lower long-term interest rates further, thereby encouraging lending, investment, and overall economic growth.

History and Origin

The concept of quantitative easing, while seemingly modern, has roots in earlier discussions of monetary policy at the zero lower bound. However, its practical application as a large-scale, explicit policy began in the early 21st century. The Bank of Japan (BOJ) was the pioneer in implementing quantitative easing, first introducing the policy in March 2001 to combat persistent deflation and economic stagnation. Under this policy, the BOJ shifted its main operational target from short-term interest rates to increasing the current account balances held by commercial banks at the central bank, primarily through extensive purchases of Japanese Government Bonds (JGBs).²⁰,¹⁹ This move was unprecedented and marked a significant milestone in the history of central banking.¹⁸

Following the 2008 global financial crisis, major central banks worldwide, including the U.S. Federal Reserve and the Bank of England, adopted quantitative easing on a much larger scale to address severe economic downturns and stabilize financial markets.¹⁷,¹⁶

Key Takeaways

• Quantitative easing is an unconventional monetary policy used by central banks when short-term interest rates are already near zero.
• It involves large-scale asset purchases by the central bank to increase the money supply and lower long-term interest rates.
• The primary goals of quantitative easing are to stimulate economic activity, encourage lending, and prevent deflation.
• Quantitative easing aims to ease financial conditions and increase market liquidity.
• Its effectiveness and long-term consequences remain subjects of ongoing debate among economists and policymakers.

Interpreting Quantitative Easing

Quantitative easing is interpreted as a signal from the central bank that it intends to maintain an accommodative monetary stance for an extended period. By purchasing large volumes of long-term assets, the central bank directly influences their asset prices and yields. The increased demand for these assets drives their prices up and pushes their yields down, leading to lower long-term interest rates across the economy. This reduction in borrowing costs is intended to encourage businesses to invest and expand, and consumers to spend, thereby boosting aggregate demand. Furthermore, the increased liquidity within the banking system is expected to facilitate more lending to businesses and households.¹⁵

Hypothetical Example

Imagine a country, "Econoland," is experiencing a severe recession with its benchmark interest rate already at 0.25%, close to the effective lower bound. Despite this, banks are hesitant to lend, and businesses are not investing, leading to stagnant economic activity.

In response, Econoland's central bank announces a quantitative easing program. It commits to purchasing $500 billion worth of long-term government bonds from commercial banks over the next year.

1. Central Bank Action: The central bank creates new digital money to buy these bonds from banks.
2. Bank Reserves Increase: Commercial banks receive this new money in exchange for their bonds, leading to a significant increase in their reserves held at the central bank.
3. Interest Rates Fall: With the central bank buying a large volume of bonds, demand for these bonds increases, driving up their prices and pushing down their yields (which move inversely to prices). This lowers long-term interest rates across the economy.
4. Lending Encouraged: Banks, now holding ample reserves and facing lower returns on safe assets like bonds, are incentivized to lend more to consumers and businesses.
5. Economic Stimulus: Lower borrowing costs encourage businesses to undertake new projects and consumers to take out mortgages or loans for large purchases. This increased spending and investment stimulate economic activity, ideally leading to job creation and higher inflation (if inflation was previously too low).

Practical Applications

Quantitative easing has been applied predominantly by major central banks as a crisis response tool and a means to combat persistent low inflation.

• Global Financial Crisis (2008): The U.S. Federal Reserve, facing a severe economic downturn and a near-zero federal funds rate, initiated multiple rounds of quantitative easing starting in late 2008. These programs involved large-scale purchases of Treasury securities and mortgage-backed securities (MBS) to lower long-term interest rates and inject liquidity into the financial system.¹⁴,¹³ The Fed's balance sheet expanded significantly as a result of these asset purchases.¹²
• Eurozone Sovereign Debt Crisis: The European Central Bank (ECB) also deployed quantitative easing later, notably through its Asset Purchase Programme (APP), to address the eurozone's economic challenges and counter deflationary pressures.¹¹
• COVID-19 Pandemic: In response to the economic shock caused by the COVID-19 pandemic in 2020, many central banks, including the Federal Reserve, once again resorted to quantitative easing to support market functioning and provide macroeconomic stimulus.¹⁰,⁹

These applications highlight quantitative easing's role in providing extraordinary monetary accommodation when traditional tools are exhausted, aiming to support stability and growth in times of crisis or prolonged economic weakness.

Limitations and Criticisms

Despite its widespread use, quantitative easing faces several limitations and criticisms. One common concern is its potential to fuel excessive inflation or create asset bubbles in markets like stocks, bonds, and real estate, although initial rounds of QE did not immediately lead to runaway inflation as some feared.⁸,⁷ Critics also argue that quantitative easing can exacerbate wealth inequality, as rising asset prices disproportionately benefit those who own financial assets.⁶

Another critique suggests that the effectiveness of quantitative easing diminishes over time and that it may foster a sense of "moral hazard" for governments, encouraging them to incur more debt due to lower borrowing costs.⁵ There are also debates about whether QE is truly effective in stimulating the real economy or if its primary impact is limited to financial markets. Some analyses suggest that while it may prevent a deep recession, its smoothing effect on the economic cycle can be limited, and returning to inflation targets may take a long time.⁴

Quantitative Easing vs. Tapering

Quantitative easing and tapering represent opposite phases of a central bank's unconventional monetary policy cycle. Quantitative easing involves the expansion of a central bank's balance sheet through the large-scale purchase of financial assets, with the goal of injecting liquidity into the economy and lowering long-term interest rates. It is a stimulative measure. In contrast, tapering refers to the gradual reduction in the pace of these asset purchases by a central bank. It is the first step towards unwinding quantitative easing and signaling a move towards a less accommodative monetary stance. The confusion between the two often arises because tapering is the process by which a central bank begins to slow down its quantitative easing program, not an outright reversal (which would be quantitative tightening).

FAQs

What assets do central banks buy during quantitative easing?

Central banks primarily purchase government bonds (such as U.S. Treasuries or Japanese Government Bonds) and sometimes other securities like mortgage-backed securities (MBS).,³ The specific types and quantities of assets purchased depend on the central bank's objectives and the structure of the financial market.

How does quantitative easing affect interest rates?

Quantitative easing is designed to lower long-term interest rates. When a central bank buys a large volume of bonds, it increases demand for those bonds, which drives their prices up. Because bond prices and yields move inversely, the yields on those bonds fall, subsequently influencing other long-term interest rates in the economy.²

Is quantitative easing the same as printing money?

While quantitative easing involves the creation of new money by the central bank to purchase assets, it is not precisely the same as traditional "printing money" that directly finances government spending (fiscal policy). In quantitative easing, the newly created money is typically used to buy financial assets from banks, increasing their reserves and aiming to encourage lending and investment in the private sector rather than directly funding government deficits.¹,

What happens after quantitative easing ends?

After quantitative easing ends, central banks may begin a process of "tapering," gradually reducing the pace of asset purchases. Eventually, they might consider "quantitative tightening," where they reduce the size of their balance sheet by allowing purchased bonds to mature without reinvesting the proceeds, or by selling assets. The goal is to return monetary policy to a more conventional footing as economic conditions improve.