What is quantitative easing? How does this affect the economy?

There are pros and cons to practicing quantitative easing.

What is quantitative easing in simple terms?

In modern finance, when the economy is going through tough times, central banks often come to the rescue with emergency monetary stimulus, known as quantitative easing (QE).

In order to increase liquidity and stimulate economic growth, the central bank buys billions of dollars of long-term securities, mainly government bonds, although it may also buy corporate bonds, municipal bonds , mortgage-backed securities and even stocks.

By buying these securities, the central bank drives down interest rates, which encourages more lending among banks which, in turn, makes it easier for their consumers to take out a mortgage or business loan, etc. .

In the United States, the Federal Reserve is in charge of monetary policy and sets target interest rates. It also manages open market operations when its members meet at its 8 annual Federal Open Market Committee (FOLMC) meetings. It is during these meetings that he sets or adjusts the federal funds rate, which is the target interest rate that banks must follow.

But what happens when this rate is already hovering around zero? What other tools can a central bank use to stimulate growth? Quantitative easing is one of them.

What happens during quantitative easing?

Quantitative easing achieves many goals:

  • It increases the money supply and provides financial markets with more liquidity.
  • It drives down long-term interest rates by raising asset prices. For example, through its Treasury buybacks, the central bank effectively increases the value of the remaining bonds that it has not purchased.
  • It increases the supply of financial reserves and expands the balance sheet of the central bank.

The sum of these factors has a considerable impact on the overall economy, leading to increased spending and investment by banks, which pass on their increase in credit to businesses and households, thus stimulating growth.

Is quantitative easing just “printing money?”

The term “printing money” is usually uttered with derision, but that’s exactly what the central bank literally does, and that’s not always a bad thing. Through quantitative easing, the central bank essentially replaces bonds and other fixed-income assets with bank reserves.

TheStreet Dictionary Terms

The central bank does not buy products or services; it’s not about buying cars, for example. It would mean more money for less goods. Through organized efforts like quantitative easing, the central bank does not give out free money; it’s more about doing what’s best and making it more attractive for banks to lend money to people – people who are qualified to repay their loans.

Thus, by using banks as intermediaries, the central bank adds safeguards against phenomena such as hyperinflation.

Is quantitative easing good or bad? Does it work?

Quantitative easing is an unconventional tactic used by central banks since the 1990s. Its proponents argue that quantitative easing is helpful. It lowers interest rates, boosts the stock market, and can even pull an economy out of a recession.

But critics believe it may actually lead to higher inflation in the long run. And without the participation of economic actors at all levels, it is not very effective. For example, if banks choose to hold and not lend their excess reserves, or if borrowers do not feel compelled to take out loans in uncertain market conditions, no one wins.

In fact, some argue that excess liquidity may actually promote higher levels of income disparity because it rewards certain sectors that not everyone can afford to participate in, such as the stock market, and may also lead asset bubbles and currency devaluation.

In theory, quantitative easing has extremely positive effects. But the jury is still out on how effective it is in the long run. In 2012, former Fed Chairman Alan Greenspan admitted that the QE cycle undertaken after the 2008 financial crisis “had very little effect on the economy”.

Does quantitative easing cause inflation?

Many say yes. If a central bank puts too much money into circulation, it can cause inflation. An extreme nightmare would be for the resulting inflation to be accompanied by little or no GDP growth. Then a phenomenon called stagflationa combustible mix of high prices, low growth and skyrocketing unemployment would occur.

What happens when quantitative easing ends?

When a central bank decides to end its injection of liquidity, the markets generally experience a temporary decline. It’s called a conical tantrum. Sometimes the central bank has to re-inject another wave of QE for it to stabilize again.

Quantitative easing vs quantitative tightening

We’ve discussed the concept of quantitative easing to help spur growth, but what if an economy overheats too quickly? This rarely happens, but a central bank can institute what is called quantitative tightening, when it reduces the supply of monetary reserves to tighten its balance sheet, essentially by allowing the bonds it has purchased to mature. When this happens, the Treasury Department removes it from its cash balance and so the money it “created” effectively disappears.

Who started quantitative easing?

The practice of quantitative easing began as early as the 1990s, when Japan’s central bank was desperate to fight decades-long inflation and stimulate the economy, although the experiment was not considered successful, as the country’s GDP actually fell during the period. A Japanese economist named Richard Werner coined the phrase “quantitative easing” in an article he wrote describing what was happening at the time.

Examples of quantitative easing in the United States

2008-2014: In response to the financial crisis that shook global markets and stemmed from the implosion of mortgage-backed securities in the United States, the Federal Reserve stepped in with emergency capital to prevent banks from reaching the insolvency. Congress approved a $700 billion cash injection, and the US Treasury added billions more through a program it called the Troubled Asset Relief Program, or TARP. In order to encourage lending and increase the money supply, the Federal Reserve also launched a series of quantitative easing measures, including investments in fragile mortgage-backed instruments. In total, the Fed’s balance sheet grew from $1 trillion to $4.4 trillion during the period.

March-June 2020: In response to the COVID-19 pandemic, the US economy experienced a global shock-induced correction. In response, the Federal Reserve instituted another round of quantitative easing by buying Treasury securities to increase market liquidity, although critics argued that this also created inflation. TheStreet’s Jim Iuorio details what the Fed needs to do next.

About Meredith Campagna

Check Also

The Federal Reserve raises interest rates by 0.75 points

The Federal Reserve took another aggressive step in its campaign to cut inflation on Wednesday, …