Explanation of quantitative easing
Quantitative Easing – or QE for short – is a monetary policy strategy used by central banks such as the Federal Reserve. With QE, the central bank buys securities in an effort to lower interest rates, increase the supply of money, and increase lending to consumers and businesses. All of this is aimed at stimulating economic activity during the financial crisis and maintaining credit flow.
What is Quantitative Easing (QE)?
When the central bank decides to use quantitative easing, it makes large-scale purchases of financial assets such as government and corporate bonds and even stocks. This relatively simple solution has significant results: the amount of money circulating in the economy increases, which helps lower long-term interest rates. This reduces the cost of borrowing, which stimulates economic growth.
This is the goal of QE: by buying securities with a longer maturity, the central bank seeks to lower long-term market interest rates. Compare this to the main instrument used by central banks: a standard rate policy that targets short-term market interest rates.
When the Federal Reserve System uses a standard interest rate policy, it adjusts its target to match the federal funds rate. The goal here is to influence the short-term rates that banks charge each other on overnight loans. The Fed has used interest rate policies for decades to keep credit flow and the US economy alive.
But when the federal funds rate dropped to zero during the Great Recession, making it impossible to further cut to encourage lending, the Fed applied quantitative easing and began buying Mortgage-backed Securities (MBS) and Treasury bonds to keep the economy from freezing.
QE is a powerful signal to the markets
Central banks like the Fed send a powerful signal to markets when they opt for quantitative easing. They tell market participants that they are not afraid to keep buying assets in order to keep interest rates low. This is a powerful signal that the Fed wants to spur economic growth and that this is having an impact on capital markets and asset prices, says Bill Merz, head of fixed income research at the U.S. Bank Wealth Management in Minneapolis. This signaling effect has been the most influential component of quantitative easing so far.
QE is used in times of great uncertainty or financial crisis that can escalate into panic in the market. Luke Tilly, chief economist at the Wilmington Trust in Philadelphia and a former economic adviser at the Federal Reserve Bank of Philadelphia, says it is designed to address both pressing financial markets problems and avert an even worse crisis. One goal is to put out a house fire, and the other is to use a fire hose to fill the system with liquidity to avoid the financial crisis, he says.
How does quantitative easing work?
Quantitative easing works through large-scale asset purchases. For example, in response to the coronavirus pandemic, the Fed began buying longer-term Treasury bonds and commercial bonds. Here’s how simply buying assets on the open market is changing the economy (mostly) for the better:
The Fed buys assets. The Fed can make money appear out of thin air – a so-called money seal – by creating bank reserves on its balance sheet. With quantitative easing, the central bank is using new bank reserves to buy long-term Treasury bonds on the open market from large financial institutions (primary dealers).
New money is flowing into the economy. As a result of these transactions, financial institutions have more cash in their accounts, which they can hold, lend to consumers or companies, or use to buy other assets.
The liquidity of the financial system is increasing. Injecting money into the economy aims to prevent problems in the financial system, such as a credit crunch, when the number of available loans decreases or the criteria for borrowing money rise sharply. This ensures the normal operation of the financial markets.
Interest rates continue to decline. When the Fed buys billions of Treasury bonds and other fixed income assets, bond prices rise (demand from the Fed rises) and yields fall (bondholders earn less). Lower interest rates make it cheaper to borrow money by encouraging consumers and businesses to borrow money for high-value goods that can help stimulate economic activity. Investors are changing the allocation of their assets.