Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy has stopped working.
It is more colloquially referred to as “printing money”, except that no actual banknotes are ever printed. Money is simply electronically “created” or “keystroked”.
“Keystroking money” or “typing up money” are more accurate phrases than “printing money”.
QE aims to raise the price of government bonds while simultaneously driving down their yields. This is a method used to push banks to invest in riskier assets and lend more to businesses and individuals.
QE is just a fancy word that describes a central bank buying “assets” from commercial banks and other private institutions.
These “assets” are typically limited to government bonds but depending on the central bank, other assets may be accepted like mortgage-backed securities (MBS) and corporate bonds.
For example, a U.S. pension fund would sell Treasury bonds to the Fed and in exchange, the pension fund would receive a deposit (money) in an account at one of the major banks, say Bank of America.
Bank of America would end up with a new deposit (a liability to the pension fund) and a new asset (central bank reserves from the Fed).
QE simultaneously increased the amount of:
- Reserves (“central bank money” that banks use to pay each other)
- Deposits (“commercial bank money” in the bank accounts of people and companies)
Only the “commercial bank money” or deposits can actually be spent in the real economy.
Reserves or “central bank money” are only used for “internal purposes”, meaning that it is money that can only be used between commercial banks and the central bank.
Think of deposits (commercial bank money) as “outside money” and reserves (central bank money) as “inside money”.
Deposits can be used as money in the outside world….the real world. Reserves can only be used inside the banking world….the network of commercial banks and the central bank.
A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions and corporate bonds.
The act of buying these assets creates new reserves (“central bank money”) that supposedly would be lent out into the real (non-financial) economy giving individuals and companies access to capital that they wouldn’t have had.
In a nutshell, QE had two simple purposes:
- QE was designed to reduce long-term interest rates in order to encourage borrowing and economic growth and to spur more risk-taking, by driving investors into stocks and non-government bonds.
- QE was also to serve as a powerful signaling effect, reinforcing the Fed’s guidance on future interest rates. By buying long-dated assets, the Fed “persuades” investors that it means what it says about keeping rates lower for longer than might otherwise have been the case.
The problem is that all this new money did NOT go into the real (non-financial) economy.
It went right back into the financial economy!
The money created through QE was used to buy government bonds from the financial markets!
Yes, the newly created money ended up going directly back into the financial markets, resulting in the bond and stock markets reaching all-time highs.
The other effect of QE is to attempt to “control” long-term interest rates.
Normally, central banks can only” influence” long-term interest rates indirectly by controlling short-term interest rates.
More on this later. But just know that usually, central banks can’t control long-term interest rates, but with QE, they can or at least try to directly.
Central banks do this by buying long-term debt like 30-year Treasury bonds. If you’re buying up all these bonds, you’re essentially increasing the demand.
So if demand increases more than supply, price rises.
And for bonds, when its price rises, their yields fall.
This is how central banks try and control long-term interest rates.
They buy longer-term bonds, reducing the supply in the market, which causes their prices to rise, which then causes their yields to fall.
So in summary, the goal of quantitative easing (QE) is to increases the excess reserves of the banks, and raise the prices of the financial assets bought, which lowers their yield.
How does QE work?
Governments and central banks attempt to maintain a “steady” economy.
They want the economy to grow but not too much where it could lead to inflation getting out of control, but not so little that there is stagnation, or even worse, it causes a recession (negative growth).
Their aim is to get the rate of economic growth “just right”.
One of the main tools they have to control growth is raising or lowering interest rates.
Lower interest rates encourage people or companies to spend money, rather than save.
But when interest rates are at almost zero, central banks need to adopt different tactics – such as pumping money directly into the financial system.
This process is known as quantitative easing or QE.
The central bank buys assets, usually government bonds, with money it has “printed” – or, more accurately, created electronically.
It then uses this money to buy bonds from investors such as banks or pension funds. This increases the overall amount of useable funds in the financial system.
Making more money available is supposed to encourage financial institutions to lend more to businesses and individuals.
It can also push interest rates lower across the economy, even when the central bank’s own rates are just about as low as they can go.
This, in turn, should allow businesses to invest and consumers to spend more, giving a knock-on boost to the economy.