What is Quantitative Easing
Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. When short-term interest rates are at or approaching zero, and when the printing of new banknotes isn't an option, quantitative easing can be considered.
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BREAKING DOWN Quantitative Easing
To execute quantitative easing, central banks increase the supply of money by buying or selling government bonds and other securities. Increasing the supply of money is similar to increasing supply of any other asset – it lowers the cost of money. A lower cost of money means interest rates are lower and banks can lend with easier terms. This strategy is used when interest rates approach zero, at which point central banks have fewer tools to influence economic growth. If quantitative easing itself loses effectiveness, fiscal policy (government spending) may be used to further expand the money supply and stimulate growth. Note that quantitative easing is often referred to as "QE."
The Drawbacks of Quantitative Easing
If central banks increase the money supply, it can cause inflation. In a worst-case scenario, the central bank may cause inflation through QE without economic growth, causing a period of so-called "stagflation." Although most central banks are created by their countries' government and are involved in some regulatory oversight, central banks can't force the banks to increase lending or force borrowers to seek loans and invest. If the increased money supply does not work its way through the banks and into the economy, QE may not be effective.
One of the key components of long-term growth of economic output is an economy's savings. In economic terms, savings equals investment. QE can suppress investment by crowding out investors because they have little opportunity for an adequate return when capital costs are low. The central bank can fill the gap by increasing the money supply, but QE cannot be sustained indefinitely. In the meantime, investors may go elsewhere for returns, which can hurt long-term growth in the economy.
Another potentially negative consequence is that quantitative easing can devalue the domestic currency. For manufacturers, this may help stimulate growth because exported goods would be cheaper in the global market. However, a falling currency value makes imports more expensive, which can increase the cost of production and consumer price levels.
Is Quantitative Easing Effective?
During the QE programs conducted by the U.S. Federal Reserve starting in 2008, the Fed increased the money supply by $4 trillion. This means that the asset side of the Fed's balance sheet grew significantly as it purchased bonds, mortgages and other assets. The Fed's liabilities, primarily reserves at U.S. banks, grew by the same amount. The goal was that the banks would lend and invest those reserves to stimulate growth.
However, as you can see in the following chart, banks held onto much of that money as excess reserves. At its peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome for the Fed's QE program.
Most economists believe that the Fed's QE program helped rescue the U.S. (and world) economy following the 2008 financial crisis. However, the magnitude of its role in the subsequent recovery is more debated and impossible to quantify. Other central banks have attempted to deploy QE to fight recession and deflation with similarly cloudy results.
Following the Asian Financial Crisis of 1997, Japan fell into an economic recession. Beginning in 2000, the Bank of Japan (BoJ) began an aggressive QE program to curb deflation and to stimulate the economy. The Bank of Japan moved from buying Japanese government bonds to buying private debt and stocks. The QE campaign failed to meet its goals. Ironically, the BoJ governors had concluded that "QE was not effective" just months before launching their program in 2000. Between 1995 and 2007, the Japanese economy fell from $5.33 trillion to $4.36 trillion in nominal terms, despite the BoJ's efforts.
The Swiss National Bank (SNB) also employed a QE strategy following the 2008 financial crisis. Eventually, the SNB owned assets nearly equal to annual economic output for the entire country, which made the SNB's version of QE the largest in the world as a ratio to GDP. Although economic growth has been positive during the subsequent recovery, how much the SNB's QE program contributed to that recovery is uncertain. For example, although it was the largest QE program in the world as a ratio to GDP and interest rates were pushed below 0%, the SNB was still unable to achieve its inflation targets.
Quantitative Easing Example
In August 2016, the Bank of England (BoE) announced that it would launch an additional QE program to help alleviate concerns over "Brexit." The plan was for the BoE to buy 60 billion pounds of government bonds and 10 billion pounds in corporate debt. If successful, the plan should have kept interest rates from rising in the U.K. and stimulated business investment and employment.
From August 2016 through June 2018, the Office for National Statistics in the U.K. reported that gross fixed capital formation (a measure of business investment) was growing at an average quarterly rate of 0.4%, which was lower than the average from 2009 through 2018. The challenge for economists is to detect whether growth would have been worse without quantitative easing.
Quantitative Easing Summary
Quantitative easing, or "QE," is the name for a broad range of strategies that a central bank can use to increase the domestic money supply, reduce the cost of capital and stimulate investment. QE is usually focused on the purchase of government bonds from banks and is used when interest rates are already near 0%. QE programs were widely used following the 2008 financial crisis, although some central banks, like the Bank of Japan, had been using QE for several years prior to the financial crisis.