Quantitative easing is a tool used by central banks to help boost an economy.
Governments and central banks work together to keep the economy growing at a stable rate. If the economy grows too fast, there is a risk of inflation becoming unmanageable and damaging growth.
If the economy grows too slowly there is a risk of deflation – setting the economy on a downward path.
Monetary policy refers to the tools the central bank has to help maintain balanced economic growth.
The most prominent of these tools is the management of interest rates. The central bank decides the level of interest rates in each country and it can raise or lower them as deemed appropriate.
The idea behind interest rate changes is that lower interest rates encourage higher levels of spending rather than saving and higher interest rates encourage saving and investment rather than spending and consumption.
After the global financial crisis of 2008, central banks across the globe lowered interest rates to encourage more spending.
The global economy had fallen into a recession and the central banks wanted to get more people spending to keep the economy growing and moving forward. This helps businesses to develop and feeds progress at all levels of society.
However, central banks had repeatedly lowered rates hoping to stimulate spending, which brought interest rates to near zero – less than zero in the case of the European Union. So, central banks were forced to turn to other methods to stimulate economic activity, and quantitative easing (QE) began.
The primary goal of QE was economic growth. This was all about managing inflation rates.
Central banks are tasked with making sure that inflation does not fall below a certain target. Lowering interest rates was not successful enough in increasing spending levels.
The economy needed more money going around it to function properly and the central bank applied QE to pump money directly into the economy.
How did it impact the market?
Central banks bought assets such as government bonds, with money it “created”. This money was most likely electronically-created money rather than printed cash. It was used buy bonds from institutional investors such as banks or pension funds, which pumped cash into the financial system.
The idea was that these financial institutions would be encouraged to lend more to businesses and individuals, which would drive economic transactions forward and produce economic growth.
How did it impact the man on the street?
QE meant that borrowing would be more achievable for businesses and individuals – they were more likely to get a mortgage and buy a home. Businesses could get loans to run and expand operations more easily, which could lead to job creation and more spending.
In addition, QE could help control inflation, which would help maintain the value of money and investments.
But on the flip side, QE was not an exact science. It could mean a risk that the strategy would overshoot and the economy would suffer from too much inflation. The QE could be more effective than intended and lead to higher price rises than intended.
Also, there was a risk that banks and financial institutions would not pass on the extra money supply, choosing not to increase lending. QE would not have the intended positive effect on the economy if these institutions did not increase lending as intended.
On the negative side QE could drive the market price of government bonds upward while reducing the yield paid out to investors – meaning investors pay more to get the same level of income.
On balance, central banks had made the decision that QE had the potential to generate enough gains to outweigh the negatives involved.
QE and its impact
According to the International Monetary Fund (IMF), the QE that was implemented post the 2007 global financial crisis was successful in mitigating some of the economically damaging effects of the crisis.
The IMF also stated that QE policies had contributed to improvements in market confidence and the bottoming out of the recession in the G7 economies in the second half of 2009.
The UK and the US applied QE after the global financial crisis and both saw positive effects on their economic progress.
The US Federal Reserve began QE in 2008 and ended its QE programme at the end of 2014. This programme involved buying bonds worth US$3.7 trillion, increasing Fed holdings eight-fold over the six-year period.
The Fed chose to end its programme of QE asset purchasing because the US was on track to meet its targets for inflation and lowered unemployment, though concerns remained that the US inflation rate could have remained persistently low.
While the US appeared to have been successful with QE, Japan’s results were mixed.
QE was first launched by Japan’s central bank to remedy deflation following financial turmoil in the 1990s. This phase of QE had mixed results, with the economy never fully recovering from pre-crisis levels.
In the UK, the Bank of England bought £200 billion worth of bonds in March and November 2009, and according to their research this boosted the UK’s annual economic output by 1.5% to 2%.
This article first appeared in The New Savvy
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