What Is Quantitative Easing?
- What Is Quantitative Easing (QE)?
- How Does Quantitative Easing Work?
- Goals of Quantitative Easing
- Does Quantitative Easing Cause Inflation?
- Benefits & Concerns of Quantitative Easing
- Qualitative Easing
- U.S. Historical Examples of QE
- How Quantitative Easing Impacts Investors
- What is Quantitative Tightening
- Bottom Line
Quantitative easing is a monetary policy action used to stimulate economic activity. The central bank purchases a large number of securities over time in hopes of increasing money supply, easing credit, and reducing interest rates. Learn more about QE and how it can affect markets.
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What Is Quantitative Easing (QE)?
The Federal Reserve has several tools at its disposal when it wants to lower interest rates and stimulate the economy. They can:
- Lower the overnight interest rate charged to commercial banks when they borrow money from the Fed.
- Lower reserve requirements to allow banks to lend more money.
- Directly purchase long-term securities to push yields down.
All of these can directly impact interest rates. The first 2 tools can influence short-term rates, while the Fed can engage in massive purchases of securities such as Treasury Bonds to impact long-term interest rates.
When the Fed purchases securities, it places more money into circulation while at the same time raising the price of long-term bonds, which then results in lower longer-term interest rates. More readily available money at lower rates incentivizes individuals and businesses to spend, which stimulates growth.
How Does Quantitative Easing Work?
Quantitative easing entails large-scale asset purchases by the Fed from financial institutions that are primary government securities dealers. The purchases are made possible by the Fed creating new bank reserves (i.e., "printing money") on its balance sheet.
This has the following effects:
- It provides financial institutions with additional capital, which they can lend out to consumers and businesses or use to buy other assets.
- Liquidity increases in the banking system, which encourages new business activity and increases consumer confidence.
- Purchases of bonds tends to put upward pressure on bond prices, lowering long-term interest rates as a result.
- As long-term interest rates decline, investors move more money into riskier securities, mainly equities.
Goals of Quantitative Easing
Quantitative easing thus serves multiple purposes:
- It puts downward pressure on long-term interest rates, which makes funding more affordable.
- It increases money supply and bank liquidity.
- It helps support financial markets.
- It instills confidence in the economy among both consumers and businesses.
QE is widely acknowledged to be successful at achieving these goals, though the Fed must use it cautiously, as it can have undesirable side effects such as increased inflation.
Does Quantitative Easing Cause Inflation?
While QE applied in the first few decades of the 21st century provided the stimulation necessary to keep the economy from slipping into a recession, it was viewed as a temporary aid and not a permanent fix.
The primary concern was that too much easing would lead to inflation, a common byproduct of having more money in circulation. Many economic regulators and experts believe that a successful monetary policy aim is to moderate economic swings in an attempt to maintain a sustainable equilibrium.
Benefits & Concerns of Quantitative Easing
While QE is acknowledged to be a useful tool for effecting monetary policy, it is not without consequences or concerns. Below is a summary of the potential benefits and concerns of quantitative easing.
Benefits
- Increases money supply: Asset purchases increase the amount of money in circulation.
- Reduces long-term interest rates: Purchases of long-term bonds puts upward pressure on bond prices, lowering interest rates.
- Instills more confidence in the economy: QE signals that the Fed is taking action to prevent a recession.
Concerns
- Can lead to inflation: Artificial increases in money supply can lead to inflation.
- Can lead to asset bubbles: Asset purchases can lead to further purchases by the public, potentially leading to asset bubbles.
- Success is difficult to prove: Academic studies are mixed on the efficacy of QE. The first QE happened in November 2008 so there isn't a long-time period in which to measure results from.
- Potential inequality: Increases in asset prices tend to disproportionately benefit those wealthy enough to own those assets.
Qualitative Easing
A related, albeit less common, monetary policy action to quantitative easing is qualitative easing. Qualitative easing involves the purchase of lower quality (i.e., “troubled") assets with offsetting sales of higher quality assets. This may or may not be accompanied by QE asset purchases that are funded by money printing.
Qualitative easing was implemented during the 2008 financial crisis under the Troubled Asset Relief Program (TARP). It was designed to purchase distressed assets such as mortgage-backed securities that could potentially have led to a ripple effect of additional failures among otherwise healthy financial institutions.
U.S. Historical Examples of QE
2008 Great Recession
Encouraged by success with QE in Europe and Japan, the Fed, under Chairman Ben Bernanke, used QE to address the financial crisis in 2008 and the following recession. Between 2009 and 2014, the Fed purchased more than $4 trillion worth of assets under a massive QE program consisting of three separate rounds.
The program, a first of its kind in the U.S., was widely acknowledged to have avoided a catastrophic impact on the financial system and enabled the country to move through the recession.
2020 COVID-19 Pandemic
On the back of its success with QE in the prior decade, the Fed implemented QE once again in response to the financial stress caused by the COVID-19 pandemic and the mass closing of businesses worldwide. Aided by QE, the COVID recession in 2020 was relatively brief and the recovery in the financial markets relatively strong during the second half of the year.
How Quantitative Easing Impacts Investors
Massive QE asset purchases by the Fed will generally have a strong positive impact on the markets. That, in turn, can certainly be a positive for investors who own assets in those markets. QE, however, is a reactionary strategy, so asset prices will likely have declined prior to the implementation of QE and initial gains may only serve to offset prior losses.
Investors may find new opportunities that result from announced QE programs, but the Fed does not always announce its intentions in this regard, making it difficult for investors to identify when, and in which markets, QE is being implemented.
For long-term investors, perhaps the greatest advantage of QE is the confidence to remain invested, rather than panic out when a crisis unfolds.
What is Quantitative Tightening
Quantitative tightening, or QT, are efforts undertaken by the Federal Reserve that are the opposite to Quantitative Easing. The Fed may increase short-term interest rates, increase reserve requirements, or sell assets back into the financial system. Each of these efforts would absorb excess liquidity in the system.
Bottom Line
Quantitative easing is a relatively new tool in the Fed’s monetary policy arsenal, having been used only twice before, with both times during the last 14 years. So far, the results appear to have been positive, though there are risks to the strategy that may not be fully apparent or measurable yet. For example, the QE used during the COVID-19 pandemic may have contributed to over-inflating the equity markets during 2020-2022, thereby contributing to the current decline in mid-2022.
As such, the Fed is likely still refining the way the technique is implemented and examining the results. Nonetheless, there is broad confidence in the action, which is seen as a valid backstop to preventing even more serious damage during times of economic stress.
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