Quantitative easing",

What Is Quantitative Easing?

Quantitative easing (QE) is an unconventional form of monetary policy implemented by a central bank to stimulate an economy when standard monetary policy tools, such as lowering short-term interest rates, become ineffective. As a tool within the broader field of monetary policy, quantitative easing involves the central bank purchasing a predetermined quantity of long-term government securities and other financial assets from commercial banks and financial institutions in the open market. This action increases the money supply and injects liquidity into the financial system, aiming to lower long-term interest rates and encourage lending and investment.

History and Origin

The concept of quantitative easing, as a novel form of monetary policy, gained widespread application following the 2008 global financial crisis. Before this period, central banks primarily influenced the economy by adjusting short-term interest rates, such as the federal funds rate in the United States.²⁷,²⁶ However, when short-term rates approached zero during the crisis, central banks, including the U.S. Federal Reserve, found themselves with limited conventional tools to combat the severe recession and prevent deflation.,

In November 2008, the Federal Reserve under then-Chair Ben Bernanke initiated its first large-scale asset purchase program, effectively beginning quantitative easing.²⁵ The goal was to push down longer-term interest rates that were not directly controlled by the federal funds rate, such as mortgage rates and business borrowing costs, to shore up the struggling economy.²⁴ Central banks in other countries, such as the Bank of Japan, had experimented with similar policies earlier, but the 2008 crisis marked the widespread adoption of quantitative easing as a critical intervention in advanced economies.

Key Takeaways

Quantitative easing (QE) is a monetary policy tool where a central bank buys large quantities of financial assets to stimulate the economy.
It is typically implemented when short-term interest rates are near zero and conventional monetary policy is no longer effective.,²³
QE aims to lower long-term interest rates, increase the money supply, and boost liquidity in the financial system.²²
The policy encourages banks to lend more freely and aims to spur economic growth and investment.,²¹
Quantitative easing expands the central bank's balance sheet through the acquisition of assets like government bonds and mortgage-backed securities.

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 long-term securities, the central bank directly impacts the prices and yields of those assets. An increase in demand for these assets, driven by central bank purchases, leads to higher bond prices and, consequently, lower yields.²⁰ This reduction in long-term interest rates is intended to make borrowing cheaper for businesses and consumers, thereby stimulating aggregate demand. The increase in bank reserves, a liability on the central bank's balance sheet, enhances the banking system's liquidity, theoretically encouraging more lending.¹⁹, The overall aim is to promote spending and investment, which can lead to job creation and economic recovery.

Hypothetical Example

Imagine a country, "Economyville," is experiencing a severe economic downturn. Its central bank, the "Reserve Bank of Economyville" (RBE), has already lowered its benchmark interest rate to near zero, but the economy remains stagnant, and credit markets are tight. To provide further stimulus, the RBE decides to implement quantitative easing.

Asset Purchases: The RBE announces it will purchase $500 billion worth of long-term government bonds and corporate bonds from commercial banks over the next 12 months through open market operations.
Increased Reserves: When the RBE buys these bonds from a commercial bank, it credits the bank's reserve account at the RBE. This increases the bank's reserves held at the central bank.
Lower Yields: The increased demand for these bonds drives their prices up. Because bond prices and yields move inversely, the yield on these long-term bonds falls.
Stimulated Lending: With lower long-term interest rates, it becomes cheaper for businesses to borrow for expansion and for consumers to take out mortgages. The commercial banks, now flush with additional reserves, are more inclined to lend to companies and households.
Economic Impact: Over time, this increased lending and lower borrowing costs lead to more business investment, housing purchases, and consumer spending, helping to boost Economyville's economic growth and move it out of recession.

Practical Applications

Quantitative easing is primarily a tool of monetary policy used by central banks during periods of severe economic distress or when conventional interest rate policies are no longer effective. Its practical applications include:

Combating Recession and Deflation: Central banks employ quantitative easing to provide additional stimulus when an economy is facing a deep recession or the threat of deflation. By lowering long-term interest rates, it aims to incentivize borrowing and spending.¹⁸
Influencing Long-Term Rates: While the federal funds rate influences short-term rates, quantitative easing allows central banks to directly impact longer-term rates, which are crucial for mortgages, business investment, and other substantial financial commitments.¹⁷
Boosting Bank Liquidity: The asset purchases inject substantial liquidity into the banking system by increasing commercial banks' reserves held at the central bank. This can encourage banks to increase lending to businesses and consumers.
Signaling Policy Intent: Quantitative easing can also serve as a strong signal from the central bank about its commitment to maintaining loose monetary conditions for an extended period, which can influence market expectations and investor behavior.
Supporting Financial Markets: By purchasing specific assets, such as mortgage-backed securities, central banks can directly support specific segments of the financial market during times of crisis. For example, during the 2008 financial crisis and the COVID-19 pandemic, the Federal Reserve expanded its balance sheet significantly through such purchases.¹⁶ The Congressional Budget Office (CBO) has analyzed how these actions affect the federal budget.¹⁵

Limitations and Criticisms

Despite its potential benefits, quantitative easing has faced several criticisms and inherent limitations.

One major concern is the potential for increased inflation. Critics argue that by vastly expanding the money supply, QE could lead to an undesirable rise in prices.¹⁴ While empirical evidence on the direct inflationary impact of QE has been mixed, some argue that it contributed to post-COVID-19 inflation.¹³

Another criticism revolves around the risk of creating asset bubbles. The influx of liquidity and lower interest rates could encourage excessive risk-taking and drive up the prices of financial assets, such as stocks and real estate, beyond their fundamental values.¹² This "search for yield" can lead to distortions in financial markets.¹¹

Furthermore, the effectiveness of quantitative easing in stimulating the real economy is debated. While it may lower long-term interest rates and boost asset prices, some argue that the transmission mechanism to increased bank lending and business investment is not always robust, especially if demand for credit remains weak. The International Monetary Fund (IMF) has also raised concerns about large balance sheet losses for central banks associated with QE and how it might shift risk within the financial system.¹⁰,⁹

Some critics also argue that quantitative easing can create moral hazard for governments by artificially depressing borrowing costs, thereby reducing the incentive for fiscal discipline.⁸ There are also concerns about the potential for central banks to exceed their mandates and distort financial markets through their extensive asset purchases.

Quantitative Easing vs. Quantitative Tightening

Quantitative easing (QE) and quantitative tightening (QT) represent opposite approaches in a central bank's monetary policy toolkit. The fundamental difference lies in their impact on the central bank's balance sheet and the overall money supply.

Quantitative easing involves the central bank purchasing large quantities of government bonds and other financial assets from the open market. This action expands the central bank's balance sheet, injects new reserves into the banking system, increases the money supply, and aims to lower long-term interest rates to stimulate the economy.⁷ QE is typically deployed during periods of low economic growth or recession when inflation is low and conventional interest rate adjustments are insufficient.

Conversely, quantitative tightening is the process by which a central bank reduces its holdings of financial assets. This can occur by allowing matured bonds to roll off its balance sheet without reinvesting the proceeds, or in some cases, by actively selling assets.⁶ QT contracts the central bank's balance sheet, drains reserves from the banking system, reduces the money supply, and aims to put upward pressure on long-term interest rates.⁵ Quantitative tightening is usually implemented when the economy is strengthening and inflation begins to rise, signaling a move towards a tighter monetary policy stance.

FAQs

What is the main goal of quantitative easing?

The main goal of quantitative easing is to stimulate economic growth when traditional monetary policy tools, like lowering short-term interest rates, are no longer effective. It aims to lower long-term borrowing costs and increase liquidity in the financial system.

How does quantitative easing affect interest rates?

Quantitative easing works by increasing the demand for long-term bonds and other securities. When demand for bonds rises, their prices increase, which in turn causes their yields (which represent interest rates) to fall. This puts downward pressure on long-term interest rates across the economy.⁴

Does quantitative easing always lead to inflation?

Not necessarily. While quantitative easing expands the money supply and theoretically carries inflationary risks, the actual impact on inflation depends on various economic factors, including the demand for money, the output gap, and expectations. In some cases, QE has been used to combat deflationary pressures.³,

What assets do central banks buy during quantitative easing?

During quantitative easing, central banks typically purchase large quantities of government bonds. They may also buy other financial assets like mortgage-backed securities (MBS) and, in some rare instances, corporate bonds or other private sector assets.,²

When was quantitative easing first widely used?

Quantitative easing became a widely adopted policy by major central banks, particularly the U.S. Federal Reserve, following the 2008 global financial crisis. It was a response to the inability of conventional interest rate cuts to further stimulate economies when rates approached zero.,¹