Quantitative Easing: Everything you need to know!

Quantitative Easing or ‘QE’ is what used to be an unconventional monetary tool used by central banks in order to stimulate economies. It was first used in Japan in 2000 in the aftermath of the Asian financial crisis of 1997. The policy became mainstream in the wake of the 2008/9 crisis where hundreds of billions of pounds were pumped into the economy by central banks.

What is QE?

The Bank of England has an explanation of QE on its website:

Quantitative easing involves us creating digital money. We then use it to buy things like government debt in the form of bonds.

Investopedia also has a great and more technical definition of what QE is:

Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy, and also serves to lower interest rates by bidding up fixed-income securities. It also expands the central bank’s balance sheet.

Put simply, QE is an extreme monetary policy tool which is used when core interest rate policy is already low (E.g. at 0.01% currently in the UK). New money is created as credit which is used to buy government bonds, and more recently company bonds in order to lower the interest rates on those instruments. By lowing the interest rates on those bonds it allows the government or company to issue more bonds to raise money as a very low cost.

If QE was not to be sufficient then a central bank could consider negative interest rates to force financial institutions to increase lending.

So they are just printing money?

Yeah they are printing money, but not in the way that most people would imagine. A lot of people would imagine the Bank of England or the Federal Reserve to create a load of money and then dish it out to the government etc. But what really happens is that the central bank will buy bonds (debt) of a government in the same way that any other investor would, just with new money.

So all these assets that central banks are holding will stay on the bank’s balance sheet until the bank either sells the asset or the government pays off the bond; thereby destroying the money that was created.

BOE balance sheet

The graph above shows the Bank of England’s balance sheet since 1700. It shows the Banks’ holdings of Government securities (bonds/debt), private assets and bullion (gold/silver). You can see that there was a massive spike in holdings during the 1940s which was the second world war peeking in 1947. The balance sheet then goes back to pre-war levels until 2008 where it goes back up peeking this year. This graph is really useful for seeing the role the Bank of England has played in helping stimulate economic activity.

fed

The diagram of the US Federal Reserve balance sheet 2008-2020 is great for seeing the roll that QE takes when trying to combat a severe economic crisis. You can see that when the down turn happened in 2008 the Federal Reserve sharply increased the amount of money in the economy and then maintained QE to sustain growth. By 2018 the economy was doing well enough that the Federal Reserve felt that it could start to off load assets at an initial rate of $10 billion per month.

The current crisis has required central banks to start QE again due to us already having low interest rates. Without QE it is possible that governments would not have been able to fund their day to day spending to help mitigate the effects of Covid-19 on the economy. Andrew Bailey, governor of the Bank of England, when asked what could have happened in the Bank had not done QE, “I think we would have a situation where in the worst element, the government would have struggled to fund itself in the short run.”

Could all of this lead to higher inflation?

Yes and no. The answer to whether QE will lead to and increase of inflation is complex and very much dependent on which country you are talking about and the way QE has been utilized.

Outside the US there is more of a chance that QE would be inflationary. So in the UK and Eurozone there is a chance that by increasing the money supply that there will be an inflationary result. But chances are you won’t notice the inflation until the recovery stage of a recession. Early in a recession consumer spending and lending fall which actually lowers the inflation rate and could risk deflation; which is why central banks lower interest rates to get you to spend and borrow more. But as the recovery gets underway and the economy is flooded with new money, it will adjust its prices accordingly along with other economic forces.

In the US it is a slightly different story. The US is able to export its inflation. I know, the concept of exporting inflation sounds mad, but bear with me…

As the US Dollar is used to price commodities and is an intermediary currency for world trade, the world reserve currency, other countries are required to hold large amounts of the Dollar. Therefore, in theory as there is constant demand for the US Dollar, the affects of increasing the supply of it can be offset; hence they have exported their inflation. However, there is a catch. This can be great in the short term allowing the US to take drastic action which would ordinarily be highly inflationary. But long term with competition from China and the Euro for use in international markets, the Dollar will not be the sole reserve currency. When that happens the US Dollar will flood the US internal market causing inflation.

 

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