What is Quantitative Easing (QE)?
Quantitative Easing (QE) refers to a form of monetary policy where the central bank attempts to encourage economic growth by purchasing long-term securities to increase the money supply.
What is the Definition of Quantitative Easing in Economics?
With quantitative easing (QE), a central bank aims to stimulate the economy with bond purchases, since increasing the money in circulation reduces interest rates.
The theory behind quantitative easing (QE) states that “large-scale asset purchases” can flood the economy with money and reduce interest rates – which in turn encourages banks to lend and makes consumers and businesses spend more.
If a country’s central bank is actively engaged in QE policies, it will purchase financial assets from commercial banks to increase the amount of money in circulation.
The types of financial assets purchased are most often the following:
- Government Bonds
- Corporate Bonds
- Mortgage-Backed Securities (MBS)
How Does Quantitative Easing Work
The process of quantitative easing is explained below:
- Step 1. Quantitative easing occurs when the central bank buys a significant amount of securities in an effort to decrease interest rates.
- Step 2. The purchase of bonds contributes to more demand, resulting in higher bond prices.
- Step 3. Interest rates and bond prices have an inverse relationship, so interest rates decline from rising bond prices.
- Step 4. The low-interest rate environment encourages more lending to consumers and corporate borrowers – plus, more capital flows into equities rather than cash and fixed-income securities with low yields.
Usually, in a country that is experiencing short-term interest rates near or at zero, consumers are saving rather than spending / investing, so the level of economic activity is low.
If interest rates become negative, however, the incentive to save money is reduced as its value is eroded by inflation.
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Quantitative easing is an unconventional monetary policy tool available to a country’s central bank, typically taken as a “last resort” (i.e. once the other monetary policy tools have proven ineffective).
Instead, the first choice is ordinarily to reduce short-term interest rates by lowering the federal funds rate, discount rate, and reserve requirements.
- Federal Funds Rate: The interest rate that banks charge each other on overnight, short-term loans (i.e. serves as the basis for short-term rates).
- Discount Rate: The interest rate that the Fed charges commercial banks and financial institutions on short-term loans.
- Reserve Requirements: The minimum amount of funds held by banks to ensure there is enough to meet unexpected liabilities.
QE works by reducing interest rates on long-term bonds, which have broader implications than changes to short-term securities.
The controversy around QE stems from how the reduction in long-term interest rates is accomplished by “flooding” the economy with money to stimulate more economic activity.
The QE strategy provides temporary, short-term economic relief, which comes with numerous risks, namely inflation:
- Rising Inflation: Given the sudden increase in the money supply, the prices of goods and services rise – stagflation or hyperinflation could also occur.
- Return to Recession: After the QE tapers off and bond purchases end, there is the possibility that the economy will resume its free fall.
- Currency Devaluation: One consequence of inflation is the diminished value of a country’s currency.
What is an Example of Quantitative Easing (QE)?
Quantitative easing (QE) became a controversial topic in March 2020 after the Federal Reserve announced its near-term plans to purchase $700 billion worth of government debt (i.e. U.S. Treasuries) and mortgage-backed securities (MBS).
The Fed’s balance sheet would substantially increase in risk at a time when it was already under scrutiny for its mounting debt pile.
Hence, concerns emerged about the Fed’s seemingly endless “money printing,” as the long-term consequences that QE will have on future generations remain unknown (and how QE will shape the economy in the future).
However, the consensus is that the quantitative easing program implemented during the recovery from the 2008 financial crisis – the criticism of the debt incurred spending aside – is considered to have achieved its goal of turning the struggling U.S. economy around.
But the pandemic-induced QE program in 2020 was arguably even worse from a debt accumulation perspective because of the current state of the Fed’s balance sheet.
Signs of inflation have emerged, illustrating the view that QE is a slippery slope.
The impact of the COVID-19 quantitative easing program will inevitably be negative to the U.S. economy – however, just how profound the magnitude and scope of its effects remain unknown.
In conclusion, the debt securities purchased by the Fed are recorded as assets on the Fed’s balance sheet, reflecting the potential long-term implications of the Fed’s quantitative easing (QE) policies.
Federal Reserve Assets, MBS & Treasury Securities (Source: FRED)
