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

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 Reserve Bank or RBA) purchases longer-term securities – often government bonds – using its cash reserves.

Where does a central bank get the funds to purchase these securities? In Australia’s case, the RBA can use its cash reserves to purchase existing government bonds in order to pump money directly into the financial system.

Understanding QE

Put simply, QE is when a central bank creates and spends large sums of cash to ease monetary policy on settings such as interest rates. 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 individuals. As less money flows into the market for available goods and services, prices generally 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 even 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. 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 they trigger a vicious cycle of lower demand, resulting in lesser economic activity, which leads to increasing unemployment.

Historical use of QE

When a central bank witnesses or even anticipates a slow down in the economy, it usually responds by trying to increase the monetary base. To do so, the first order of business for policymakers is generally to cut target interest rates (or in other words, the ‘official cash rate’), to as low a level as possible.

The United States Federal Reserve and most other major central banks maintain target interest rates by buying and selling government bonds in the open market. However, the law of supply and demand breaks down once the interest rate is zero. At that point, the bank resorts to unconventional methods and tools, and QE 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 increased inflation without the desired increase in economic activity. Economists call such a situation a ‘liquidity trap’, where investors do not invest in businesses and instead, 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 of the most dreaded situations any central bank must deal with because it makes monetary policy ineffective – even QE.

Also, with high unemployment, policymakers can’t increase interest rates because this 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, which further fuels 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 – rampant QE-induced inflation could ultimately contribute to the devaluation of the dollar in the long run.

Example of QE

Central banks 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 faced 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 to keep the interest rate close to zero, thereby flooding the current account balance of commercial banks. This eventually flowed through to the economy, with GDP growing between 2002 and 2007. Like many countries worldwide, however, Japan saw negative growth in the wake of the global financial crisis (GFC). 

In 2007, the US Federal Reserve and the Bank of England (BOE) resorted to similar policy responses. Again, QE helped restore positive economic growth. Following negative GDP growth in 2008 and 2009, the US returned to positive GDP growth from 2010 until 2019. The coronavirus crisis, however, saw GDP in the US fall by 3.5% in 2020. 

In response, the Federal Reserve lowered interest rates to close to zero and started buying long-term bonds. It inflated its balance sheet to mitigate the impact of COVID-19 on the unemployment rate. It reached a high of close to 15% in 2020 but  dropped to below 5% by the end of 2021. 

In Australia, the RBA implemented QE for the first time ever in 2020, also in response to the coronavirus crisis. GDP fell by 0.3% in Australia in 2020 but as the economy recovered, more jobs were created and  the unemployment rate fell throughout most of 2021. From a high of more than 7% in 2020, Australia’s unemployment rate recovered to close to 4.5% by the end of 2021. 

 

Updated 27 January 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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