Quantitative easing (QE) is a monetary policy tool that central banks can turn to when the normal mechanisms of monetary policy have reached their limits, such as when short-term interest rates are at or near zero. Many central banks (Japan, the U.K., the U.S.) have employed QE, which involves increasing central bank reserves (also known as the size of the central bank's balance sheet) by purchasing assets outside the standard range of short-term government securities.
The advantage of QE is that it gives central banks more options for stimulating the economy when standard policy tools exhaust themselves. The biggest risk of QE is that it is nearly the same as "printing money," and-if mismanaged-could lead to inflation or possibly hyperinflation. However, as Japan's experience with QE demonstrates, QE does not automatically lead to inflation, nor is its effectiveness guaranteed either.
A response to the "zero bound" on interest rates
Normally, central banks like the U.S.'s Federal Reserve Bank implement monetary policy by buying or selling short-term government debt (e.g., T-bills) on the open market until the interest rate on those securities falls into the central bank's target range. Buying more bills tends to lower the interest rate; buying less or selling raises it, and the change in the cost of money to banks and securities dealers filters through to influence credit and loans available to businesses and consumers across the entire economy. This effectively expands or contracts the money supply.
When short term interest rates are at or near zero percent, however, purchasing more short-term Treasury securities becomes ineffective as a monetary policy tool. After all, no one would choose a security that offers negative interest when one could simply hoard cash under a mattress and receive 0%. So, once interest rates reach 0%, central banks cannot push rates any lower and the standard policy has reached its limit (although real interest rates can go below 0% if inflation is high enough). When the "zero bound" is reached on short-term interest rates, a central bank will need to purchase something else if it wants to increase the economy's money supply.
Strictly speaking, quantitative easing is when central banks increase the duration or maturity scale for the type of government debt they are willing to buy. So instead of buying only securities with less than one-year maturity, the Fed might decide to purchase up to five-year notes in order to provide banks with capital ready to lend more to businesses and consumers.
Why is it called quantitative easing?
The "quantitative" in quantitative easing refers the increasing the quantity of the central bank's assets (i.e., the size of its balance sheet). "Easing" refers to the expected effect on credit and the money supply: i.e., making money easier to acquire. In normal monetary policy, the size of the central bank's balance sheet may change somewhat from day to day, but in quantitative easing, the size of the balance sheet and the supply of bank reserves (measured by economists as "M0") change dramatically.
In theory, when bank reserves increase, the total credit outstanding should increase proportionately. However, in the U.S., this has not happened. Just why is hotly debated, and the subject of a future piece.
Credit easing vs. pure quantitative easing
It is worth pointing out that what U.S. analysts refer to as QE-1 (the first round of quantitative easing in the United States, initiated during the crisis of 2008) is, technically, more than pure quantitative easing. This is because QE-1 involved not just increasing the size of the balance sheet, but also moving down the credit spectrum to include U.S. agency securities and mortgage-backed securities as well as some short-term corporate debt.
Pure quantitative easing simply increases the supply of sovereign debt on reserve at the central bank; QE-1 included a substantial portion of credit securities not guaranteed by the U.S. government. Ben Bernanke himself described this as "credit easing," basically placing the U.S. Fed as the lender of last resort for these non-government securities, and effectively placing a floor on their price by being willing to buy them.
Credit easing is potentially problematic because it degrades the quality of assets on the Fed's balance sheet, and transfers the risk that private investors bore to the entire economy. If these non-U.S. instruments default, then the money that was created by the Fed purchasing them effectively becomes permanent, resulting in inflation.
It is also true that should these non-U.S. government instruments mature or be sold at a profit, the U.S. dollar will deflate (i.e., strengthen) somewhat. That may ultimately happen, because these securities were sold in a panic at possibly bargain prices, but the job of the central bank is not to speculate on the value of assets with the currency of the nation, but to ensure honest, predictable measures of value for the U.S. dollar. One can argue that credit easing was necessary at the time to prevent something worse-and this is probably correct-but the question of how to "unwind" these assets and improve the credit quality of the central bank's assets remains an important macro question.
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