Basics of "Quantitative Easing"

Quantitative easing (QE) is a monetary policy whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to inject money into the economy to expand economic activity.  Quantitative easing is considered to be an unconventional form of monetary policy, which is usually used when inflation is very low or negative, and when standard monetary policy instruments have become ineffective.

Similar to conventional open-market operations used to implement monetary policy, a central bank implements quantitative easing by buying financial assets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply.  However, in contrast to normal policy, quantitative easing involves the purchase of riskier assets (rather than short-term government bonds) of predetermined amounts at a large scale, over a pre-committed period of time.

Central banks usually resort to quantitative easing when their nominal interest rate target approaches or reaches zero. Very low interest rates induces a liquidity trap, a situation where people prefer to hold cash or very liquid assets, given the low returns on other financial assets. This makes it difficult for interest rates to go below zero; monetary authorities may then use quantitative easing to further stimulate the economy rather than trying to lower the interest rate further.

Quantitative easing can help bring the economy out of recession and help ensure that inflation does not fall below the central bank's inflation target.  However QE programmes are also criticized for their side-effects and risks, which include the policy being more effective than intended in acting against deflation (leading to higher inflation in the longer term), or not being effective enough if banks remain reluctant to lend and potential borrowers are unwilling to borrow. Quantitative easing was undertaken by all major central banks worldwide following the global financial crisis of 2007–08, and again in response to the COVID-19 pandemic.

Process and Benefits

Standard central bank monetary policies are usually enacted by buying or selling government bonds on the open market to reach a desired target for the interbank interest rate.  However, if a recession or depression continues even when a central bank has lowered interest rates to nearly zero, the central bank can no longer lower interest rates — a situation known as the liquidity trap.  The central bank may then implement quantitative easing by buying financial assets without reference to interest rates. This policy is sometimes described as a last resort to stimulate the economy.

A central bank enacts quantitative easing by purchasing, regardless of interest rates, a predetermined quantity of bonds or other financial assets on financial markets from private financial institutions.  This action increases the excess reserves that banks hold. The goal of this policy is to ease financial conditions, increase market liquidity, and encourage private bank lending.

Quantitative easing affects the economy through several channels:

• Credit channel: By providing liquidity in the banking sector, QE makes it easier and cheaper for banks to extend loans to companies and households, thus stimulating credit growth. Additionally, if the central bank also purchases financial instruments that are riskier than government bonds (such as corporate bonds), it can also increase the price and lower the interest yield of these riskier assets.
• Portfolio rebalancing: By enacting QE, the central bank withdraws an important part of the safe assets from the market onto its own balance sheet, which may result in private investors turning to other financial securities. Because of the relative lack of government bonds, investors are forced to "rebalance their portfolios" into other assets. Additionally, if the central bank also purchases financial instruments that are riskier than government bonds, it can also lower the interest yield of those assets (as those assets are more scarce in the market, and thus their prices go up correspondingly).
• Exchange rate: Because it increases the money supply and lowers the yield of financial assets, QE tends to depreciate a country's exchange rates relative to other currencies, through the interest rate mechanism.  Lower interest rates lead to a capital outflow from a country, thereby reducing foreign demand for a country's money, leading to a weaker currency. This increases demand for exports, and directly benefits exporters and export industries in the country.
• Fiscal effect: By lowering yields on sovereign bonds, QE makes it cheaper for governments to borrow on financial markets, which may empower the government to provide fiscal stimulus to the economy. Quantitative easing can be viewed as a debt refinancing operation of the "consolidated government" (the government including the central bank), whereby the consolidated government, via the central bank, retires government debt securities and refinances them into central bank reserves.
• Boosting asset prices: When a central bank buys government bonds from a pension fund, the pension fund, rather than hold on to this money, it might invest it in financial assets, such as shares, that gives it a higher return. And when demand for financial assets is high, the value of these assets increases. This makes businesses and households holding shares wealthier – making them more likely to spend more, boosting economic activity.
• Signalling effect: Some economists argue that QE's main impact is due to its effect on the psychology of the markets, by signalling that the central bank will take extraordinary steps to facilitate economic recovery. For instance, it has been observed that most of the effect of QE in the Eurozone on bond yields happened between the date of the announcement of QE and the actual start of the purchases by the ECB.

Effectiveness of QE

The effectiveness of quantitative easing is the subject of an intense dispute among researchers as it is difficult to separate the effect of quantitative easing from other contemporaneous economic and policy measures, such as negative rates.

Former Federal Reserve Chairman Alan Greenspan calculated that as of July 2012, there was "very little impact on the economy".  The straightforward reason was that little of the money ostensibly created by QE ever made it into circulation. Banks and other financial institutions simply re-deposited it in the Fed. Bank deposits in the Fed increased by nearly $4 trillion during QE1-3, closely tracking Fed bond purchases. The bond purchase program amounted to little more than an exercise in journal entry bookkeeping at the Fed. A different assessment has been offered by Federal Reserve Governor Jeremy Stein, who has said that measures of quantitive easing such as large-scale asset purchases "have played a significant role in supporting economic activity".

While the literature on the topic has grown over time, it has also been shown that central banks' own research on the effectiveness of quantitative easing tends to be optimistic in comparison to research by independent researchers, which could indicate a conflict of interest or cognitive bias in central bank research.

Several studies published in the aftermath of the crisis found that quantitative easing in the US has effectively contributed to lower long term interest rates on a variety of securities as well as lower credit risk. This boosted GDP growth and modestly increased inflation.  A predictable but unintended consequence of the lower interest rates was to drive investment capital into equities, thereby inflating the value of equities relative to the value of goods and services, and increasing the wealth gap between the wealthy and the working class.

In the Eurozone, studies have shown that QE successfully averted deflationary spirals in 2013-2014, and prevented the widening of bond yield spreads between member states.  QE also helped reduce bank lending cost.  However, the real effect of QE on GDP and inflation remained modest and very heterogeneous depending on methodologies used in research studies, which find on GDP comprised between 0.2% and 1.5% and between 0.1 and 1.4% on inflation. Model-based studies tend to find a higher impact than empirical ones.

Risks and Side-Effects of QE

Quantitative easing may cause higher inflation than desired if the amount of easing required is overestimated and too much money is created by the purchase of liquid assets.  On the other hand, QE can fail to spur demand if banks remain reluctant to lend money to businesses and households. Even then, QE can still ease the process of deleveraging as it lowers yields. However, there is a time lag between monetary growth and inflation; inflationary pressures associated with money growth from QE could build before the central bank acts to counter them.  Inflationary risks are mitigated if the system's economy outgrows the pace of the increase of the money supply from the easing.  If production in an economy increases because of the increased money supply, the value of a unit of currency may also increase, even though there is more currency available. For example, if a nation's economy were to spur a significant increase in output at a rate at least as high as the amount of debt monetized the inflationary pressures would be equalized. This can only happen if member banks actually lend the excess money out instead of hoarding the extra cash.  During times of high economic output, the central bank always has the option of restoring reserves to higher levels through raising interest rates or other means, effectively reversing the easing steps taken.

Economists such as John Taylor believe that quantitative easing creates unpredictability. Since the increase in bank reserves may not immediately increase the money supply if held as excess reserves, the increased reserves create the danger that inflation may eventually result when the reserves are loaned out.

QE benefits debtors, since the interest rate has fallen, meaning there is less money to be repaid. However, QE directly harms creditors as they earn less money from lower interest rates.  Devaluation of a currency also directly harms importers and consumers, as the cost of imported goods is inflated by the devaluation of the currency.

Impact on savings and pensions

In the European Union, World Pensions Council (WPC) financial economists have also argued that artificially low government bond interest rates induced by QE will have an adverse impact on the underfunding condition of pension funds, since "without returns that outstrip inflation, pension investors face the real value of their savings declining rather than ratcheting up over the next few years".  In addition to this, low or negative interest rates create disincentives for saving.  In a way this is an intended effect, since QE is intended to spur consumer spending.

Effects on climate change

In Europe, central banks operating corporate quantitative easing (i.e. QE programmes that include corporate bonds) such as the European Central Bank or the Swiss National Bank, have been increasingly criticized by NGOs for not taking into account the climate impact of the companies issuing the bonds.  In effect, Corporate QE programmes are perceived as indirect subsidy to polluting companies. The European Parliament has also joined the criticism by adopting several resolutions on the matter, and has repeatedly called on the ECB to reflect climate change considerations in its policies.

Central banks have usually responded by arguing they had to follow the principle of "market neutrality" and should therefore refrain from making discretionary choices when selecting bonds on the market. The notion that central banks can be market neutral is contested, as central banks always make choices that are not neutral for financial markets when implementing monetary policy.

However, in 2020, several top level ECB policymaker such as Christine Lagarde, Isabel Schnabel, Frank Elderson and others have pointed out the contradiction in the market neutrality logic. In particular, Schnabel argued that "In the presence of market failures, market neutrality may not be the appropriate benchmark for a central bank when the market by itself is not achieving efficient outcomes."

Since 2020, several central banks (including the ECB, Bank of England and the Swedish central banks) have announced their intention to incorporate climate criteria in their QE programmes.  The Network for Greening the Financial System has identified different possible measures to align central banks' collateral frameworks and QE with climate objectives.

Increased income and wealth inequality

Critics frequently point to the redistributive effects of quantitative easing. For instance, British Prime Minister Theresa May openly criticized QE in July 2016 for its regressive effects: "Monetary policy – in the form of super-low interest rates and quantitative easing – has helped those on the property ladder at the expense of those who can't afford to own their own home."  Dhaval Joshi of BCA Research wrote that "QE cash ends up overwhelmingly in profits, thereby exacerbating already extreme income inequality and the consequent social tensions that arise from it".  Anthony Randazzo of the Reason Foundation wrote that QE "is fundamentally a regressive redistribution program that has been boosting wealth for those already engaged in the financial sector or those who already own homes, but passing little along to the rest of the economy. It is a primary driver of income inequality".

Those criticisms are partly based on some evidence provided by central banks themselves. In 2012, a Bank of England report showed that its quantitative easing policies had benefited mainly the wealthy, and that 40% of those gains went to the richest 5% of British households.

In May 2013, Federal Reserve Bank of Dallas President Richard Fisher said that cheap money has made rich people richer, but has not done quite as much for working Americans.

Answering similar criticisms expressed by MEP Molly Scott Cato, the President of the ECB Mario Draghi once declared:

Some of these policies may, on the one hand, increase inequality but, on the other hand, if we ask ourselves what the major source of inequality is, the answer would be unemployment. So, to the extent that these policies help – and they are helping on that front – then certainly an accommodative monetary policy is better in the present situation than a restrictive monetary policy.

In July 2018, the ECB published a study showing that its QE programme increased the net wealth of the poorest fifth of the population by 2.5 percent, compared with just 1.0 percent for the richest fifth. The study's credibility was however contested.

International spillovers for BRICs and emerging economies

Quantitative easing (QE) policies can have a profound effect on Forex rates, since it changes the supply of one currency compared to another. For instance, if both the US and Europe are using quantitative easing to the same degree then the currency pair of US/EUR may not fluctuate. However, if the US treasury uses QE to a higher degree, as evidenced in the increased purchase of securities during an economic crisis, but India does not, then the value of the USD will decrease relative to the Indian rupee.  As a result, quantitative easing has the same effect as purchasing foreign currencies, effectively manipulating the value of one currency compared to another.

BRIC countries have criticized the QE carried out by the central banks of developed nations. They share the argument that such actions amount to protectionism and competitive devaluation.  As net exporters whose currencies are partially pegged to the dollar, they protest that QE causes inflation to rise in their countries and penalizes their industries.

In a joint statement leaders of Russia, Brazil, India, China and South Africa, collectively BRICS, have condemned the policies of western economies saying "It is critical for advanced economies to adopt responsible macro-economic and financial policies, avoid creating excessive liquidity and undertake structural reforms to lift growth" as written in the Telegraph.

According to Bloomberg reporter David Lynch, the new money from quantitative easing could be used by the banks to invest in emerging markets, commodity-based economies, commodities themselves, and non-local opportunities rather than to lend to local businesses that are having difficulty getting loans.

Moral hazard

Another criticism prevalent in Europe is that QE creates moral hazard for governments. Central banks’ purchases of government securities artificially depress the cost of borrowing. Normally, governments issuing additional debt see their borrowing costs rise, which discourages them from overdoing it. In particular, market discipline in the form of higher interest rates will cause a government like Italy's, tempted to increase deficit spending, to think twice. Not so, however, when the central bank acts as bond buyer of last resort and is prepared to purchase government securities without limit. In such circumstances, market discipline will be incapacitated.

Reputational risks

Richard W. Fisher, president of the Federal Reserve Bank of Dallas, warned in 2010 that QE carries "the risk of being perceived as embarking on the slippery slope of debt monetization.  We know that once a central bank is perceived as targeting government debt yields at a time of persistent budget deficits, concern about debt monetization quickly arises."  Later in the same speech, he stated that the Fed is monetizing the government debt: "The math of this new exercise is readily transparent: The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation's central bank will be monetizing the federal debt."

Ben Bernanke remarked in 2002 that the US government had a technology called the printing press (or, today, its electronic equivalent), so that if rates reached zero and deflation threatened, the government could always act to ensure deflation was prevented. He said, however, that the government would not print money and distribute it "willy nilly" but would rather focus its efforts in certain areas (e.g., buying federal agency debt securities and mortgage-backed securities).

According to economist Robert McTeer, former president of the Federal Reserve Bank of Dallas, there is nothing wrong with printing money during a recession, and quantitative easing is different from traditional monetary policy "only in its magnitude and pre-announcement of amount and timing".

             https://en.wikipedia.org/wiki/Quantitative_easing

See also the Daily Quiddity entry for December 19, 2013.