What is Quantitative Easing (QE)?

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Definition:

Quantitative easing refers to actions by central banks to inject money into the financial system by buying long-term assets from banks in an effort to boost the economy.

🤔 Understanding quantitative easing

Quantitative easing (QE) is an extraordinary action that central banks can take to try to stimulate the economy by injecting money into the financial system. While central banks like the Federal Reserve Bank often buy and sell short-term securities to keep a benchmark interest rate at its target level, QE is an expansionary monetary policy designed to get the economy moving. It almost always occurs during a recession, when short-term interest rates are already near zero and inflation rates are very low or negative. QE can include buying long-term government bonds or even riskier assets. Exchanging these long-term securities for cash frees up money for lending within the banking system, reduces interest rates, and stimulates the economy.

Example

The world’s major central banks — including the Federal Reserve, Bank of England, European Central Bank, and the Bank of Japan — engaged in a quantitative easing (QE) program during the global financial crisis of 2008. QE was necessary after a significant number of defaults led to an inability or unwillingness among banks to make more loans. Without access to credit, people couldn’t expand their businesses or make significant purchases. Consequently, the decrease in economic activity led the world into a recession. With interest rates already very low, central banks turned to QE to try to get the financial markets going again.

Takeaway

Quantitative easing is like priming the pump…

After sitting in the garage all winter, your lawn mower might not start up very easily in the spring. When it’s time to cut the grass for the first time, you might need to give the motor a kickstart to get it going. A few pushes on the primer button injects some gasoline into the carburetor, which helps to get the cold engine running again. Similarly, quantitative easing injects money into the financial system to help jumpstart the economy.

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What is quantitative easing (QE)?

Quantitative easing (QE) is an extraordinary action that a nation’s central bank can take to expand the money supply — it is one tool used to execute monetary policy. QE involves asset purchases of long-term bonds and loans as a way to encourage more lending, thus stimulating the economy.

QE is different from typical monetary policy. Normally, central banks buy and sell short-term financial assets to control a benchmark interest rate. QE occurs when the interest rate is already very low, and the central bank wants to encourage more lending.

In the wake of the COVID-19 pandemic, the Federal Reserve has reached deeper into its playbook to perform QE. It’s now lending money directly to small and large companies as well as municipalities.

How does quantitative easing work?

Quantitative easing (QE) works by pumping money into the financial sector of the economy. Before explaining the process, it’s worth taking a moment to appreciate how the financial system works. Financial institutions earn a profit by borrowing money from depositors, then investing that money in financial assets. The most common banking activity is issuing a loan. But banks can also purchase corporate bonds, sell Certificates of Deposit (CDs), or invest in collateralized debt obligations (CDOs).

While the bank is holding the financial asset, it receives a stream of payments over time. But the principal is tied up, so the bank can’t make more investments until it receives more deposits, gets payments from its investments, or sells assets.

When the central bank wants to promote economic growth, it encourages consumers to borrow more and save less. Under normal circumstances, the central bank can accomplish that goal by lowering the benchmark interest rate. But if the interest rate is already close to zero, that’s not an effective strategy.

In that case, the central bank might try to encourage member banks to offer more loans by improving their balance sheets (aka company’s assets and liabilities). If the central bank buys a 20-year bond from a member bank, that frees up money for the bank that would have been tied up for 20 years. In other words, the bank is able to increase its liquidity, easing the stress and allowing it to make new loans or buy other assets.

Is quantitative easing the same as printing money?

Not exactly, but it’s close. When people talk about printing money, they usually mean one of two things. They might be talking about the physical act of a printing press putting ink on paper. Or they may be speaking figuratively about the government’s ability to create fiat money (currency that has value only because the government says it does). In history, those two things were very closely related. In modern times, that’s less true.

In the United States, two government agencies participate in the management of the money supply. The US Treasury collects tax money, issues government debt instruments, prints the paper dollars, and mints the coins that circulate. The Federal Reserve oversees the banking system, controls interest rates, and manages the government’s financial assets (including gold, bonds, and foreign currency).

On every paper bill that the Treasury prints, it places the words “Federal Reserve Note” across the top of the front. That’s because every paper bill is a liability on the Federal Reserve's balance sheet. In the past, the holder of a paper bill could bring that note to the central bank and exchange it for gold or silver. Now that the world has moved beyond the gold standard, that’s no longer the case. Money only has value because we accept it as legal tender. So the Federal Reserve can expand its balance sheet without printing redeemable notes — All it takes is a few keystrokes.

When people talk about printing money today, they usually mean it figuratively. It’s a reference to expanding the Federal Reserve’s balance sheet. In that way, quantitative easing is similar to printing money — even if it isn’t literally “printing” the money.

What is the relationship between quantitative easing and inflation?

Quantitative easing (QE) would typically lead to inflation (a broad increase in prices), but other market forces are also at work. So a nation might not always see rising prices as a result of QE. For instance, if the US economy were to experience a 3% rate of deflation (a broad decrease in prices) during the year without any intervention, and QE caused a 3% inflation rate, you wouldn’t necessarily observe any change in overall prices.

In theory, a well-timed monetary policy would continually offset the natural rate of inflation or deflation to achieve an inflation target. That could require QE when the threat of deflation is high, followed by contracting the money supply as the economy recovers.

Who pays for quantitative easing?

Nobody pays for quantitative easing (QE) in a literal sense, but everyone is impacted by it. QE is different from government debt. When the US government wants to spend more money than it raises in taxes, it issues Treasury bills, notes, and bonds. The buyers of those debt instruments pay for the US deficit spending; then taxpayers pay back those buyers in the future — with interest.

With QE, there’s no debt issuance. Instead, the Federal Reserve simply adds money to its balance sheet. It then uses the expanded money supply to purchase financial assets from banks. By taking this action, each US dollar becomes less valuable than before (since more dollars are competing for the same amount of products). That means that any dollars a person had before QE began has less purchasing power than before. In a way, that means that everyone who uses dollars pays for QE.

What are the advantages and disadvantages of quantitative easing?

Quantitative easing (QE) has the advantage of raising money without owing any interest, but has the disadvantage of increasing prices. In theory, the US Treasury could issue bonds, which the Federal Reserve could then immediately purchase from its members. In that case, the Treasury would owe interest to the Federal Reserve, whose profits belong to the Treasury. So it’s a wash.

However, the Federal Reserve would need to expand the money supply to buy those bonds. Expanding the money supply causes inflation. That means that although taxpayers wouldn’t end up paying for the debt service, they could end up with less purchasing power through an invisible tax (inflation).

Is quantitative easing effective?

The effectiveness of quantitative easing (QE) depends on timing and how you measure success. Correctly timed QE can free up banks to make more loans when the credit market has been frozen. It’s an unconventional monetary policy approach that is necessary when the federal funds rate (the benchmark interest rate, set by the Federal Reserve, that banks charge each other for overnight loans) is near zero and interest rates can't go any lower. QE is useful during a recession to get the economy moving again.

During the global financial crisis of 2008, many central banks attempted to use QE to thaw out the credit market. The United States even passed a bank bailout called the Troubled Asset Relief Program (TARP), alongside the Federal Reserve’s QE program. Whether or not those efforts worked depends on how you measure success.

The programs did prevent many banks from failing, and those banks repaid all of the money used to bail them out. In that regard, the effort was effective in preventing further economic destruction without causing massive inflation or adding to the national debt.

However, the QE program didn’t result in the level of new bank lending that the Federal Reserve expected. Many banks simply kept the influx of cash in their vaults rather than loaning it out. So, in that respect, the QE program wasn’t as effective.

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