What Is Quantitative Easing?
Quantitative Easing or QE is a popular monetary policy implemented by a central bank in which the central bank buys long-term fixed income securities from banks in the public markets with newly-created bank reserves in order to increase the supply of money in an economy.
The money of the central bank flows into the market and provides new money and liquidity to banks, which can in turn loan this money to businesses and individuals. This injects large sums of money into the economy to encourage spending and investment.
The large-scale purchases by the central bank lower interest rates by bidding up the prices of the fixed income securities, which also encourage borrowers to borrow money at lower interest rates and spend and invest in the economy.
Most central banks set and implement monetary policy to manage the supply of money in order to keep inflation at around 2% per year. And central banks aim to prevent deflation, which could hurt the economy.
Quantitative Easing and Inflation
Inflation is the increase of an average price of a specific basket of goods in an economy during a specific period of time.
Due to a rise in the price of the goods, a unit of currency buys fewer units of the goods than the currency did prior to the increase in price. Therefore, the currency loses its purchasing power.
The opposite of inflation is deflation.
In quantitative easing, the central bank normally purchases government bonds, mortgages, corporate debt, and other highly-liquid securities. Increasing the supply of money can cause inflation as there is suddenly more money in the economy that is chasing the same number of goods and services.
If the rate of inflation increases above the intended moderate inflation rate target of the central bank, the increase in prices of goods in the economy could hurt the economy. The cost of living could increase for the average person, and without a corresponding increase in wages, people will become poorer. This will lead to less money available for savings and investments for individuals and businesses.
If quantitative easing leads to inflation but the new money supply does not lead to increased growth in the economy, this is called stagflation.
The Effectiveness of Quantitative Easing
The central bank such as Federal Reserve, Bank of Canada, Bank of England, Reserve Bank of Australia, or European Central Bank is responsible for managing the supply of money in an economy.
The goal of quantitative easing is to supply money to the economy in order to promote business and consumer spending and investment. It is meant to stimulate an economy into growth.
However, a central bank cannot force banks to actually loan this money to consumers and businesses. And banks cannot force consumers and businesses to actually borrow money and spend and invest this new money.
These are the limits of quantitative easing. The central bank can only hope that it has provided sufficient incentive to banks, consumers, and businesses to spend and invest the money.
The effectiveness of quantitative easing will be determined by the financial incentives such as low interest rates and the overall economic sentiment in the economy.
Consumer and Investor Sentiment
In the case of a recent market failure such as a stock market crash or housing market collapse in which many investors lost money, the result may be an overall decline in investor sentiment and an increase in economic pessimism about the future.
Many individuals and businesses may choose to save their money for a rainy day. Thus, they will choose to not borrow money from the banks and will spend less money on goods and services in the marketplace.
In this case, the quantitative easing program will not be effective.
Banks
Banks are a critical and vital player in any quantitative easing program. Banks act as intermediaries and are meant to loan the money from the central bank to individuals and businesses.
But in some cases, even the banks that receive new money to loan to individuals and business may be pessimistic about the future of the economy and choose to hold on to the money in their reserves. As such, the money does not make its way into the economy and there is no increase in spending and investments to grow the economy.
In this case, the quantitative easing program will not be effective.