Quantitative Easing Explained | EE Essentials

Quantitative easing, or QE for short, is an important but controversial tool that central banks use to control their economies. At its core, QE is the central bank printing money to increase business activity and stimulate the economy during times of recession. But it's not as simple as just creating new money and putting it in the pockets of ordinary people. The central bank prints money to buy long-dated financial instruments, typically government bonds. Financial assets like government bonds obey the laws of supply and demand, no different than any other good. If you go to your local farmer's market and buy $1 million worth of apples, demand will increase, and the price of apples will go up. For the same reason, if the Federal Reserve goes to the Treasury market and puts in an order to buy $1 trillion worth of government bonds, the price of these bonds will also go up. And this can have a big economic impact. The interest rate on a bond is inversely related to its price. Let's say you can pay $90 to buy a bond which will pay you $100 after holding it for one year. By holding the bond, you effectively collect an 11% interest rate. If the price goes up to $95, the interest rate decreases by about 5%. This is important because almost all interest rates across the economy are based off government bonds' yields. For example, if you get a 30-year mortgage, you might pay something like whatever the interest rate on the 30-year government bond is, plus a 2% markup. By decreasing the interest rate on government bonds, just about everyone in the economy can borrow money at lower interest rates. And the lower the interest rate, the more people borrow. If the mortgage rate is 3% instead of 5%, you may take out a larger loan to buy a larger house. A company may issue more bonds to build a larger factory. All of this stimulates demand, creates jobs, and can be a big help to pull an economy out of recession. But central banks have been setting interest rates long before quantitative easing. So what makes QE special? When you hear about the Federal Reserve or Bank of Canada cutting or hiking interest rates, this is referring to the short-term policy rate. For example, in the US, this policy rate is called the Federal Funds Rate and represents the rate commercial banks borrow money from each other overnight. This short-term borrowing rate isn't very relevant for pricing long-term loans, like 30-year mortgages. If the central bank wants to decrease the interest rate for 10-year government bonds, they have two options. Firstly, they can promise to keep the policy rate low for the next 10 years. This is called forward guidance. If people expect interest rates to stay at 1% for the next 10 years, they will be willing to buy a 10-year bond at a yield of 1%. However, if people believe interest rates will rise five years from now, they won't want to lock in the low interest rate now since they can get a higher one in the future. So forward guidance only works if investors believe what the central bank tells them, which is not always the case. The major advantage of quantitative easing is that it doesn't require the market to believe the central bank. The central bank goes into the open market and buys long-dated assets, such as 10-year treasury bonds. This directly increases the price and thus decreases the yield, regardless of future expectations for the policy rate. While QE usually involves the purchase of government bonds, it doesn't have to. The central bank can also buy private sector assets, like corporate bonds or mortgage-backed securities. This is a more direct way to lower borrowing costs in the real economy. But does any of this work in practice? Many advanced economies have implemented QE policies since the 2008 financial crisis, most notably the US, EU, UK and Japan. In all these economies, QE has effectively reduced interest rates on long-term government and corporate bonds. Banks have more money to lend out and businesses have access to cheaper financing. In theory, businesses will use this money to expand their operations and hire new workers, which has been the purpose of QE from the beginning. The problem is, a lot of commercial banks have just let the extra cash pile up on their balance sheets instead of making new loans. And for the money they did lend to corporations, a lot of this was used to fund share repurchases. The volume of corporate buybacks in the US increased tenfold from $10 billion per quarter before the financial crisis to a peak of $100 billion in 2016. Share repurchases decreased the number of shares outstanding, giving the existing shareholders a larger stake in the company. And just like how the Fed's purchases of government bonds push up bond prices, corporate repurchases push up their stock price. This is great for the shareholders, but it doesn't directly create any jobs. Of course, rising share prices can be good for the economy as well. Large shareholders will become even richer, allowing them to buy more private jets and sports cars. This increased demand does help the economy to some extent, but it also increases the gap between the rich and the poor as stocks are disproportionately owned by the wealthiest segments of society. That's one of the biggest criticisms of QE. When you print trillions of new dollars to buy financial assets, the only thing you know for sure is that the prices of said financial assets will go up. The central bank can't force companies to build new factories or hire new workers. This is exemplified by Japan, which has pursued perhaps the most aggressive QE policy of any nation. Over the past two decades, the Bank of Japan has printed $6 trillion, which is more than 100% of their current GDP to buy government bonds, corporate bonds and even common shares. Despite this, the economy has stagnated with negligible growth compared to other advanced countries. Of course, it's difficult to prove the counterfactual. Maybe things would have been even worse without QE. Another big criticism of QE is its impact on inflation. Central banks can print as much money as they want, but this does not come without a cost. If you increase the supply of money without increasing the number of goods and services in the economy, there will be more money chasing fewer goods. Prices will rise, meaning the purchasing power of each dollar is diminished. If businesses used their newfound capital to increase their productive capacity, this would increase the aggregate supply of goods and services, which would offset the increase in money supply. But, as we explained earlier, a lot of this money goes to share repurchases instead of business investment. The post-pandemic QE policies of global central banks have almost certainly contributed to the 40-year high inflation we're seeing across the US and Europe today.