There are pros and cons to the practice of quantitative easing.
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What Is Quantitative Easing (QE) in Simple Terms?
In modern finance, when the economy hits a rough patch, central banks often come to the rescue with emergency monetary stimulus, known as quantitative easing (QE).
In order to increase liquidity and help spur economic growth, the central bank buys trillions of dollars’ worth of long-term securities, mainly government bonds, although it can also purchase corporate bonds, municipal bonds, mortgage-backed securities, and even stocks.
By purchasing these securities, the central bank drives interest rates lower, which fosters more lending among the banks who, in turn, make it easier for their consumers to take out a mortgage or a 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 (FOMC) meetings. It is during these meetings that it sets or adjusts the Fed Funds Rate, which is the target interest rate for banks to follow.
But what happens when that rate is already hovering around zero? What are some other tools a central bank can use to spur growth? Quantitative easing is one of them.
What Happens During Quantitative Easing (QE)?
Quantitative easing achieves numerous goals:
It increases the monetary supply and provides financial markets with more liquidity.It drives down long-term interest rates by increasing asset prices. For instance, through its Treasury buybacks, the central bank effectively raises the value of the leftover bonds it did not purchase.It increases the supply of financial reserves and expands the central bank’s balance sheet.
The sum of these factors has a tremendous impact on the overall economy, resulting in increased spending and investment from banks, who pass on their expanded credit to companies and households, thus spurring growth.
Is Quantitative Easing Just “Printing Money?”
The term “printing money” is usually uttered with derision, but the central bank is literally doing just that—and that’s not always a bad thing. Through quantitative easing, the central bank is basically swapping out bonds and other fixed-income assets for bank reserves.
The central bank is not buying products or services; it’s not buying cars, for example. Doing so would mean more money chasing fewer goods. Through organized efforts like quantitative easing, the central bank isn’t giving away free money; rather, it’s doing the next best thing and making it more attractive for banks to lend people money—people who are qualified to pay their loans back.
So, by using banks as intermediaries, the central bank is adding safeguards against phenomena like hyperinflation.
Is Quantitative Easing Good or Bad? Does It Work?
Quantitative easing is an unconventional tactic that has been employed by central banks since the 1990s.Its proponents argue that quantitative easing helps. It lowers interest rates, boosts the stock market and can even lift an economy out of a recession.
But critics believe it can actually lead to higher inflation over the long term. And without participation from economic players at every level, it’s not very effective. For example, if banks choose to hold and not lend their excess reserves, or if borrowers don’t feel compelled to take out loans under uncertain market conditions, nobody wins.
In fact, some argue that the excess cash can actually foster higher levels of income disparity, because it rewards certain sectors that not everyone can afford to participate in, such as the stock market, and can also lead to asset bubbles and currency devaluation.
In theory, quantitative easing has tremendously positive effects. But the jury’s still out on just how effective it is in the long term. In 2012, Former Fed Chairman Alan Greenspan admitted that the round of QE 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. One nightmare extreme would be if the resultant inflation is accompanied by little to no GDP growth. Then, a phenomenon called stagflation, a combustible mix of high prices, little growth, and skyrocketing unemployment, would occur.
What Happens When Quantitative Easing Ends?
When a central bank decides to end its infusion of liquidity, the markets usually experience a temporary downturn. It’s called a taper tantrum. Sometimes, the central bank must re-inject another round of QE to get it to settle back down again.
Quantitative Easing vs. Quantitative Tightening
We’ve discussed the concept of quantitative easing to help spur growth, but what happens if an economy becomes overheated too quickly? This rarely happens, but a central bank may institute what is known as quantitative tightening, when it reduces the supply of monetary reserves in order to tighten its balance sheet, basically by letting the bonds it has bought reach maturity. When this happens, the Treasury department would remove it from its cash balance and thus the money it has “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 to be successful, since the country’s GDP actually fell during the period. A Japanese economist by the name of 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 rocked global markets and stemmed from the implosion of U.S. mortgage-backed securities, the Federal Reserve stepped in with emergency capital to prevent banks from reaching insolvency. Congress approved a $700 billion liquidity injection, and the U.S. Treasury added billions more through a program it called the Troubled Asset Relief Program, or TARP. In order to encourage lending and increase the monetary supply, the Federal Reserve also began a series of quantitative easing measures, including investment in the fragile mortgage-backed instruments. In total, the Fed’s balance sheet ballooned from $1 trillion to $4.4 trillion over the timeframe.
March–June 2020: In response to the COVID-19 pandemic, the U.S. 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 have argued that doing so also created inflation. Although the Fed has initiated a quantitative tightening process to reverse the effects of “money printing,” TheStreet’s Carley Garner believes there is still an unfathomable amount of money sloshing around the economy.