What is Quantitative Easing (QE) and How Does It Work?

Quantitative easing (QE) is the process by which a central bank (in Australia’s case, the RBA) purchases longer-term securities (often government bonds) using its cash reserves. 

Where does a central bank get the funds to purchase the banks’ securities? Well, this is where you might hear the term ‘printing money’; in our case the RBA can use their cash reserves to purchase existing government bonds, in order to pump money directly into the financial system.

Understanding quantitative easing

Put simply, QE is when a central bank creates and spends large sums of cash to ease monetary policy. However, let’s try to look at that in more depth.

During an economic downturn, money supply tends to contract as private banks become fearful of lending to corporations and private individuals. As less money flows in the market for available goods and services, the overall prices drop, and the economy faces deflationary pressure.

Nominally, deflation appears to be a good thing in the short run, as the cost of buying things goes down for consumers. But it also prompts them to delay major purchasing decisions in anticipation of lower prices in the future. As a result, businesses cut production as demand goes down. 

For example, imagine that you want to buy a house. Would you buy it now if you expect the price to fall by an additional 20% within the next year? Probably not. So, when home builders anticipate less demand, they also stop building new houses. This phenomenon happens in almost all sectors of the economy when overall price levels start to fall.

As you can see, falling prices intensify the slowdown in economic activity, as it triggers a vicious cycle of lower demand resulting in fewer economic activities, which leads to increasing unemployment.

Historic use of QE

When a central bank witnesses or even anticipates a slowdown in the economy, it usually responds by trying to increase the monetary base. To do so, the first order of business for the policymakers is generally to cut target interest rates to as low as possible.

The United States Federal Reserve and most other major central banks maintain target interest rates by buying and selling government bonds with the open market operation. However, the law of supply and demand breaks down once the interest rate is lowered to zero. At that point, the bank resorts to unconventional methods and tools, and quantitative easing is one of them.

Historically, central banks have used QE when the short-term interest rate reaches near-zero and traditional monetary policy tools have become ineffective. 

Special considerations with QE

The main risk of QE is increasing inflation, but at the same time, not stimulating economic activity. Economists call such a situation a ‘liquidity trap’ where investors do not invest in businesses and keep cash at hand despite the low-interest rates. As a result, the QE program ends up contributing to stagflation, where inflation goes up, but the unemployment rate remains high.

Stagflation in the economy is one the most dreaded situations any central bank must deal with as it makes monetary policy, even QE, ineffective.

Also, with high unemployment, policymakers cannot simply consider increasing interest rates, as it would further intensify the recession. Hence, investors and speculators stop anticipating an increase in interest rates despite a high inflation rate. Consequently, the currency of the economy starts losing value against other major foreign currencies, further fuelling inflation.

While the US dollar enjoys “exorbitant privilege” as the world’s reserve currency and is often treated as a safe haven for foreign capital, QE-induced rampant inflation could ultimately contribute to the devaluation of the dollar in the long-run.

Example of quantitative easing

Central banks from around the world have experimented with QE but the Bank of Japan (BOJ) was the first to utilise this policy tool. 

In the early 2000s, the Japanese economy was facing massive deflationary pressure despite the BOJ leaving the interest rate close to zero since 1999. In March 2001, the BOJ started buying more government bonds and required to keep the interest rate close to zero, therefore flooding the current account balance of commercial banks.

After the subprime-induced global financial crisis in 2007, the US Federal Reserve and the Bank of England (BOE) resorted to similar policy responses.

More recently, the Federal Reserve dropped interest rates close to zero, started buying long-term bonds and inflated its balance sheet to mitigate the sharp decline in the unemployment rate due to the COVID-19 pandemic.

In Australia, the RBA actually implemented quantitative easing for the first time ever in 2020, also in response to the coronavirus crisis.

Updated 4th August, 2021. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.