What is quantitative easing? Purpose, benefits, and risks

What is quantitative easing in economics?

Quantitative easing (QE) is a nontraditional monetary policy tool used by central banks to increase the money supply and stimulate economic activity. It involves buying financial assets from financial institutions, such as government bonds and mortgage-backed securities (MBS), to lower longer-term interest rates and ease financial conditions. It can also be used to help prevent deflation, which is a decrease in the general price level of goods and services.

How does quantitative easing work?

Quantitative easing comes into play when interest rates are near zero, and the economy's growth slows down. When this happens, the central banks must increase the supply of circulating money in the economy. This is done electronically, and not by printing physical bills.

These purchases lower long-term yields, encourage investors to shift into riskier assets, and ease financial conditions. The goal is to stimulate borrowing, spending, and investment during periods of weak economic growth.

Concurrently, the central bank will use the increased money supply to buy financial assets from banks, such as government or sometimes corporate bonds, and other securities. Not only does this increase the demand for bonds, lowering interest rates, but participating banks receive extra liquidity from the asset sales, making them more willing to lend.

Together, this strategically boosts economic activity, encouraging growth in times of economic distress.

Examples of quantitative easing

In 2008, as the US economy struggled through a recession precipitated by the global financial crisis (GFC); the Federal Reserve (Fed) found itself in a precarious position. Despite having reduced interest rates to near zero, the economy continued struggling, showing little to no signs of life. To resuscitate it, the US central bank decided to implement QE, easing credit conditions for banks, pension funds and other financial institutions to stimulate aggregate demand.

This innovative policy tool differed from traditional monetary policy in several ways. Firstly, it involved the Fed purchasing long-term bonds. Secondly, the Federal Reserve Bank also began purchasing private mortgage-backed securities, something it had never done before. By pushing both long-term interest rates down and stabilising financial markets, the central bank managed to renew confidence and strengthen the financial system. In late 2014, the Fed ended the program after the unemployment rate had fallen to just under 6 percent.

What are the benefits of quantitative easing?

When quantitative easing is deployed to stimulate the economy, it can benefit lower-income households through job growth. The financial sector can also benefit from lower financing costs.

While quantitative easing provides liquidity to financial markets, it can also lead to inefficiencies, such as asset bubbles. By raising asset prices such as equities and real estate, QE may disproportionately benefit wealthier households, potentially widening wealth inequality.

The wealth effect

When central banks push down interest rates, they encourage consumers to take loans, which increases consumer spending and, over time, contributes to inflation. During this period of loose monetary conditions, asset prices (stocks, real estate) rise, which creates a wealth effect amongst wealthier households. This leads to increased consumer spending and fuels inflation.

Quantitative easing conditions also influence inflation expectations. If both businesses and consumers believe that the central bank's actions will lead to higher inflation in the future, they may adjust their behaviour to this expectation and inadvertently add to the inflationary environment.

When it comes to financial markets, the introduction of quantitative easing can add liquidity to the banking system. When this liquidity is introduced, financial institutions are typically more willing to lend, which can lead to a greater availability of credit for consumers and businesses, which enhances market liquidity.

Risks and side-effects of quantitative easing

Quantitative easing is an innovative tool, and when used surgically, it can help to stabilise the economy, encourage both consumer spending and investment, but it can also contribute to inflation.

That said, whilst QE can contribute to inflationary pressures if implemented during strong economic conditions, the post-2008 experience showed that QE alone does not automatically generate high inflation.

Other risks include asset price distortions, financial imbalances, and challenges in unwinding central bank balance sheets.

To avoid some of the downside risks of quantitative easing, central banks also have an innovative monetary policy tool called quantitative tightening (QT). It is a contractionary monetary policy which decreases the amount of liquidity and bank reserves, which tightens financial conditions. It is the opposite of quantitative easing and involves central banks selling bonds or letting them mature. It is also known as balance sheet normalisation, the result of which causes a reduction in the central bank's balance sheet.

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Quantitative easing also introduces the risk of policy uncertainty. If the central bank misjudges the necessary amount of quantitative easing required, it may result in unintended consequences which benefit borrowers and investors over savers.

What is the impact of Quantitative Easing on inequality?

Quantitative Easing can have a mixed effect on inequality. While on the one hand it might have the potential to reduce income inequality by lowering unemployment and compressing the income distribution, on the other hand it also has the potential to exacerbate inequality by benefiting financial markets more than the broader economy.

Quantitative Easing is now a mainstream monetary policy tool

In 2009, the Bank of England (BoE) also introduced quantitative easing in response to the global financial crisis. Just as the US central bank had done across the Atlantic, the BoE also bought long-term government bonds financed through the issuance of newly created interest-paying reserves to encourage consumer spending and put upward pressure on inflation.

Although the Fed may have made the idea of quantitative easing popular, it was first pioneered by the Bank of Japan in 2001 and following the financial crisis, it has also been deployed in Switzerland, Australia, and Canada. Since its introduction, the policy tool has been repeatedly used, including in other emerging market countries in response to the COVID-19 pandemic.

Quantitative Easing FAQs

When do central banks typically intervene using Quantitative Easing?

Central banks intervene to resuscitate the economy using quantitative easing during periods of heightened financial stress when interest rates are already near zero to make credit conditions less tight, stimulate aggregate demand, provide liquidity, reduce volatility, and restore confidence to the market.

Does Quantitative Easing cause inflation?

Yes, when central banks ease credit conditions and increase money supply to the financial system to boost economic growth, it can lead to increased consumer spending/investment, a rise in asset prices, and a decline in the currency's purchasing power, all of which may result in inflation.

What is Quantitative Tightening

When the central banks want to reduce the money supply in an economy, they deploy a policy tool called quantitative tightening. It is the opposite of quantitative easing, and it involves selling financial assets such as government bonds from the central bank’s balance sheet to remove excess liquidity and control rising inflation.

What is the potential risk of Quantitative Tightening?

When central banks want to reduce the money supply in the economy, one of the major risks is that it can significantly tighten financial conditions and, if mishandled, can contribute to market stress.

Who benefits most from Quantitative Easing?

Initially, banks and financial institutions are the main beneficiaries of quantitative easing as they receive the money from the central bank when it buys assets. Investors and wealthy households who hold financial assets also benefit, but the long-term goal is for everyone to benefit from the stimulated economy and lower unemployment rate which comes from it.

What is the impact of Quantitative Tightening on tax revenue?

If QT significantly slows economic activity, it could indirectly reduce tax revenues due to weaker growth.

What happens to central bank balance sheets during periods of Quantitative Easing?

The Federal Reserve's balance sheet expands significantly during periods of quantitative easing as it purchases substantial amounts of Treasury securities and mortgage-backed securities.

What happens when quantitative easing causes stagflation risk?

If QE contributes to inflation without sufficiently supporting real economic growth, it could exacerbate stagflation risks under certain conditions.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.