What is Quantitative Easing?
Quantitative easing (QE) is an advanced monetary policy of central banks to stimulate growth in a stagnant economy by large scale buying of government bonds and other assets. QE attempts to influence an economy by issuing more money to enhance the money supply. It does not involve printing more cash. Instead, the central bank creates new money by purchasing securities electronically and updating the transactions in its balance sheet.
The measure comes as an alternative to revive investment, consumption and prices when standard monetary policies have failed to increase growth.
- Quantitative easing is a corrective measure of country’s central bank to induce new money in its slowed economy by bulk purchases of government or corporate securities from the open market.
- Quantitative easing aims at economic stability and growth during financial crisis with the idea that boosting the money supply will increase consumers’ buying power, investments and productivity. It will pass on the growth spur to aggregate demand, prices, wages, and employment – putting an end to deflation.
- The reversal of a Quantitative easing program at the right time is equally important to avoid the adverse effects like hyperinflation or stagflation.
Quantitative Easing Explained
Quantitative easing is an aggressive monetary policy of central banks such as the Federal Reserve adopted during an economic crisis like the Great Depression. Normally, central banks influence inter-bank overnight lending interest rates to increase or decrease the money supply in the economy.
A decrease in overnight lending rate eventually decreases overall borrowing rates in the economy, which helps consumers borrow more. With more money in hand, consumption, demand and business improve, gradually putting the economy back on track. However, lowering the interest rates to zero cannot force banks to lower borrowing rates if they aren’t willingly which counters the policy. Resultantly, to increase the money supply, central banks switch to quantitative easing policies which do not involve printing new banknotes.
Instead, the central bank creates new money by electronically buying government bonds and other assets from the open market. The central bank’s balance sheet records this transaction, throwing light on the virtually added money. As part of its quantitative easing measures, the Fed had decided to indefinitely buy $120 billion bonds each month in March 2020. It was to help the economy recover after being battered with Covid-19.
How does Quantitative Easing Affect an Economy?
The idea of Quantitative easing is that when the central bank bulk buys government bonds and some long-term securities from the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces., it increases their demand. As a result, bond pricesBond PricesThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows. climb up with high demand, lowering their yields as bond price and yield have an inverse relationship.
Due to low returns, investors start switching to other securities in the capital marketCapital MarketA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets. for higher earnings. Resultantly, stock market investment goes up with booming stock prices. In 2020, S&P 500 fell by over 30% from its record highs due to the pandemic. But, with the help of the US government’s stimulus and other elements, it rose over 70% from March falls. In fact, the stock market turned bullish after a few months.
Additionally, buying assets from other banks increases their reserve balance tremendously. The availability of money with banks increases, enabling them to lower rates to induce borrowings. With ease in borrowing, investment increases. Governments also add to this by introducing fiscal policies such as the US’s government signing a $1.3 trillion Covid relief stimulus. It involves direct lending to most Americans worth $1400.
With more money circulating, borrowing rates fall further. People save less as they earn less on their savings and bank accounts, so they spend more. Therefore, if Quantitative easing measures work, they can increase the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices. and prices. When businesses earn more, they produce and hire more. With improved GDPGDPGDP or gross domestic product refers to the sum of the total monetary value of all finished goods and services produced within the border limits of any country. GDP determines the economic health of a nation. GDP = C + I + G + NX and employment rates, the economic growth revives.
Quantitative Easing Examples
When we talk about quantitative easing in economics, United States, Europe and Japan get an obvious mention. For example, during the 2009 financial crisis, the Bank of England purchased 200 billion pounds bonds as part of QE and has relied upon the measure many times. In 2020, it bought 895 billion pounds of bonds in response to the pandemic slowdown.
Over the years, emerging economies such as Philippines, Indonesia, South Africa, etc., have also adopted the QE methodology for economic well-being. Let us take two countries and see how they have implemented quantitative easing.
Japan’s Quantitative Easing Timeline
Japan plunged into a mild deflationDeflationDeflation is a decrease in the prices of goods and services caused by negative inflation (below 0%). It usually results in increased consumer purchasing power, owing to a simple supply and demand rule in which excess supply leads to lower prices. in 2000. As part of the monetary policy, the Bank of Japan (BOJ) kept interest rates near zero for years since 1999. The country also introduced negative interest rates, which dissuades banks from keeping reserves instead of lending.
Over the years, the central kept pumping more liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. into the economy to enhance lending facilities. In 2014, BOJ announced the expansion of its bond-buying program to buy $723.4 billion of bonds a year. Due to the effect of aggressive quantitative easing, Japan’s balance sheet had expanded by $4.5 trillion in 2020. Japan also adopted yield curve control as part of QE.
Under yield curve control, it lowered the yield on its 10-year government bond to zero to drive up investments in other securities in the capital market. However, Japan still has not been able to increase inflation to the target 2%. Consumers are risk-averse. Instead of increased spending due to high money circulation, consumers are saving. Bank deposits of customers especially post Covid-19, grew to $ 7.4 trillion in 2020.
US Quantitative Easing Timeline
During the peak of the financial crisis in 2008, the Fed applied various quantitative easing measures in multiple phases, i.e., QE1, QE2 and QE3. It reduced interest rates to zero and started asset-buying on a massive scale. It bought millions of mortgage-backed debt (MBD) and Treasury notes.
By 2014, the Fed had bought more than $3 trillion Treasuries and MBS and its balance sheet had swelled by $4 trillion. Over the years, the country has implemented many QE programs, helping it survive economic crises of different times. To battle the pandemic economic woes, the central bank has been buying $120 billion bonds per month since March 2020, $80 billion in Treasury assets and $40 billion of MBD.
Criticisms of Quantitative Easing
Many economists are wary of QE policies as they aren’t sure of their efficacy. Critiques argue that there is no guarantee of an economic recovery using QE. Moreover, it requires precision to be able to timely pull back some measures as enhanced money influx can lead to a string of problems, including inflation. Let us take a look at some of the criticisms of QE.
- With the value of currency depreciating due to heavy injection of money into the monetary system, inflation could rise steeply. As such, quantitative easing is linked to increase in inflation beyond the accepted level of 2%. Sustained QE policies could send the economy into hyperinflation.
- In the US, with the Fed’s 2020 quantitative easing purchases, the Consumer Price Index increased 4.5% from 2020. CNBC recently reported that as per an official of the central bank, tapering of bond buying will possibly start by the end of 2021. It will slow down the bond and asset purchases, allowing the economy to recover more naturally.
- QE also lowers the currency’s purchasing power which increases import prices. Resultantly, the cost of domestic goods and services will go up and people will struggle with affordability.
- Besides, the central bank can only do so much, i.e. decrease interest rates to zero, and lower yields on government bonds. It cannot force financial institutions to extend loans or lower rates if they don’t want to do so.
- Similarly, when people are not confident about the economic revival, they’d also hold onto their savings fearing economic security. This is one of the main reasons behind Japan’s extended deflation, lack of consumer confidence.
- Relying on QE as a tool is criticized by many economists. Some say it enhances income inequality when it makes money easily available to those with plenty. Also, inflation widens income gap. Many suggest that stock market index represents only a section of the market. Billions are still jobless after the pandemic even when the stock prices have been improved.
- As such, while prolonged QE measures could lead to inflation. If an economy is lost in artificial booming numbers, a reversal of the policy could push it into stagnation without the real growth.
The central bank issues new money by buying government and corporate securities from the open market as part of the quantitative easing policy. Large scale buying of government bonds increases their cost and decreases their interests, driving people to other investment securities to earn more. With more credit in the system, overall borrowing rates fall, leading to more borrowing, consumption and increased growth. Resultantly, it enhances business, prices, profits, wages and employment.
Quantitative easing does not involve the printing of new banknotes and giving them away. Instead, the bank buys securities electronically, not using its existing balance but with a virtual supply of new money. With this, the bank’s balance sheet increases.
Too much quantitative easing mostly increases inflation, sometimes to the extent of hyperinflation, since excessive money supply in the economy leads to a drop in its purchasing power.
This has been a guide on what is Quantitative Easing (QE). Here we discuss its definition along with examples from Japan, the US, UK, ECB and the process of Quantitative Easing. You may have a look at these below articles for further learnings –