Central Bank Policies: Quantitative Easing

Quantitative easing, often abbreviated as ‘QE,’ is a monetary strategy typically employed by central banks to invigorate their domestic economies when conventional measures have been exhausted. In this approach, the central bank acquires assets, usually government bonds, from its member banks, thereby injecting more money into the economy.

By increasing the money supply, the cost of borrowing decreases, making it more affordable for businesses to secure funds for expansion. This has a similar impact to the standard method of lowering short-term interest rates that central banks employ. However, depending on the assets acquired, this approach can also reduce the cost of longer-term loans, which can directly influence lending for activities like buying homes, cars, and supporting small businesses.

As the overseer of the United States’ monetary system, the Federal Reserve (Fed) is entrusted with establishing a stable and flexible financial framework that promotes steady inflation and low unemployment. This mission is distilled into a dual mandate. To fulfill these goals, the Fed wields a range of tools that allow it to influence the money supply and the value of the US Dollar. While adjusting the Federal Funds rate is the most well-known tool, the central bank’s balance sheet has gained significant importance and garnered the attention of investors.

In simple terms, the Fed’s balance sheet resembles any other financial statement. For the Fed, it documents various assets and liabilities held by its different branches. These assets and liabilities can serve as non-traditional or supplementary tools of monetary policy, particularly in situations where interest rates are already at minimal levels and offer limited scope for further policy action.

A government might simultaneously execute its fiscal policy to increase the money supply. While the Fed can impact the money supply, the U.S. Treasury Department has the authority to generate fresh money and enforce novel tax strategies through fiscal policy, injecting funds into the economy either directly or indirectly. QE can emerge as a fusion of both monetary and fiscal measures.

Examples of QE

U.S.

In the backdrop of the 2008 recession triggered by the Global Financial Crisis (2007–2008 financial crisis), the Fed implemented a series of interest rate reductions. These standard measures aimed to stimulate spending and bolster the economy. However, even with interest rates near zero, economic recovery remained elusive.

Subsequently, in November 2008, the Fed introduced its first round of QE, commonly referred to as QE1. This marked a significant departure from its usual market operations as the Fed embarked on substantial purchases of government treasury instruments, bonds, as well as high-quality asset- and mortgage-backed securities. These purchases effectively pumped more money into the US economy and reduced the cost of borrowing. This program continued from December 2008 to March 2010, running alongside another reduction in the Fed Funds rate, leading to an interest rate range of 0 to 0.25%.

Subsequent efforts led to further expansion of the Fed’s balance sheet through the acquisition of bonds, mortgages, and various other assets, and resulted in the accumulation of U.S. bank reserves that surpassed $4 trillion by 2017, furnishing a source of liquidity to facilitate lending and drive broader economic expansion. Unexpectedly, banks retained around $2.7 trillion in excess reserves, a consequence not initially foreseen within the Fed’s QE program.

Later, in 2020, the Fed unveiled a plan to purchase $700 billion worth of assets as an emergency measure under its QE approach, prompted by the economic and market upheaval triggered by the COVID-19 shutdown. However, in 2022, the Fed underwent a significant shift in its monetary strategy, encompassing substantial increases in interest rates and a reduction in the volume of assets held by the Fed. These actions were taken to counteract the persistent rise in inflation that had surfaced in 2021.

Japan

After the occurrence of the 1997 Asian Financial Crisis, Japan experienced an economic downturn. To counter deflation and spark economic growth, the Bank of Japan (BOJ) initiated a forceful QE initiative, during which it embarked on purchasing trillions in Yen worth of commercial paper. This endeavor aimed to assist banks during a period marked by sluggish growth, low interest rates, and challenges stemming from problematic bank loans. However, this effort yielded limited results as growth remained lackluster.

In response, the Bank of Japan escalated its asset purchases further between March 2001 and December 2004. This wave of acquisitions focused on long-term government bonds and infused 35.5 trillion Yen into the liquidity of Japanese banks. While these purchases yielded moderate effectiveness, they also suppressed asset yields due to the acquisition of long-term government bonds. As the Great Financial Crisis emerged, Japan’s growth once again waned. In the aftermath, the Bank of Japan undertook numerous rounds of QE and qualitative monetary easing (QQE), none of which significantly improved the situation as the nation grappled with sluggish economic growth, despite a backdrop of negative interest rates.

In present times, the Bank of Japan has diversified its asset purchases, albeit with varying degrees of impact. In addition to previous commercial paper acquisitions, the bank has amassed significant ownership within the country’s exchange traded fund (ETF) market and Japanese real estate investment trusts (J-REITs).

Europe

The European Central Bank (ECB) is another significant central bank that has embraced quantitative easing as an expansionary tool, although its adoption of this now-standard practice came notably later than that of the Fed. Between March 2015 and December 2018, the ECB allocated nearly $3 trillion toward the acquisition of government bonds, corporate debt, asset-backed securities, and covered bonds. This purchasing activity aimed at averting the European bloc from sinking into deflation. The region was still grappling with recovery from the dual challenges of the Global Financial Crisis and the Eurozone Debt Crisis.

Similar to Japan’s experience, the ECB’s rounds of easing yielded rather limited results. In early 2019, the bank introduced another round of easing through targeted long-term refinancing operations (TLTROs), shortly after concluding its open-ended QE program and as interest rates remained at 0%. TLTROs deliver low-interest rate funding to Eurozone banks to bolster bank liquidity and lower sovereign debt yields. These loans possess a maturity ranging from one to four years.

The primary objective of TLTROs is to enhance the stability of private banks’ balance sheets and their liquidity ratios. A stronger liquidity ratio empowers banks to lend more readily, consequently exerting downward pressure on interest rates and theoretically fostering inflation.

More recently, the ECB, like the Fed, has shifted its monetary policy to counteract the rise in inflation. (We will look at the current strategy in our upcoming educational articles.)

In August 2016, the Bank of England (BoE) initiated a QE initiative aimed at mitigating the potential economic impacts of Brexit. The strategy involved purchasing 60 billion pounds’ worth of government bonds and an additional 10 billion pounds in corporate debt. The objective was to prevent a rise in interest rates and to encourage business investments and employment opportunities.

By June 2018, the Office for National Statistics in the U.K. indicated that gross fixed capital formation was experiencing an average quarterly growth rate of 0.4%, which was lower compared to the average rate observed from 2009 to 2018. U.K. economists faced difficulties in determining whether this QE program had a definitive impact on growth, leaving uncertainty about whether growth would have occurred without it.

Lastly, in the aftermath of the 2008 financial crisis, the Swiss National Bank (SNB) similarly adopted a QE strategy, amassing assets that exceeded the annual economic output of the entire country. Although this approach spurred economic growth, it remains unclear how much of the subsequent recovery can be attributed to the SNB’s QE program.

Effects of QE

The majority of economists contend that the Fed’s implementation of the QE program played a vital role in rescuing both the U.S. and global economies in the aftermath of the 2007–2008 financial crisis. However, quantifying the outcomes of QE proves challenging.

On a global scale, central banks have endeavored to utilize QE as a strategy to avert recession and deflation within their respective nations, yet the conclusive effects remain elusive. While QE policies effectively reduce interest rates and elevate the stock market, their broader ramifications on the overall economy remain unclear.

Typically, the impacts of QE favor borrowers over savers and investors over non-investors, and the pros and cons associated with QE are subject to debate.

There are certain ‘risks’ associated with QE, such as inflation. As the money supply grows within an economy, the specter of inflation emerges. As this increased liquidity circulates through the system, central banks remain watchful due to the typical 12 to 18 months delay between the money supply increase and the inflation rate rise. A strategy of QE that fails to stimulate the desired economic growth but triggers inflation can also result in stagflation; a situation where both inflation and unemployment rates are elevated.

Another risk faced is potential limited lending during QE. While liquidity increases for banks, central banks like the Fed lack the ability to compel banks to ramp up lending activities or to induce individuals and businesses to borrow and invest. This can lead to a credit crunch, where funds remain stashed at banks or corporations hoard cash due to an uncertain business environment.

Furthermore, QE can lead to the devaluation of the domestic currency as the money supply expands. Although a devalued currency can offer benefits to domestic manufacturers by making exported goods more competitively priced in the global market, a falling currency value also raises the cost of imports, thereby increasing production expenses and consumer price levels.

QE critics have contended that it essentially equates to printing money and cite historical instances where this practice has resulted in hyperinflation. In contrast, advocates of QE assert that banks function as intermediaries, channeling funds indirectly to individuals and businesses. They argue that this intermediary role mitigates the potential for triggering uncontrollable inflation.

The Bottom Line

QE denotes a monetary strategy wherein a central bank, such as the U.S. Federal Reserve, engages in purchasing securities via open market operations to amplify the money supply and stimulate bank lending and investment. Although QE policies have been adopted worldwide, their effects on a nation’s economy are frequently a topic of contention and discussion.