Quantitative Easing (QE) Explained: Meaning, Advantages and How it Works with Examples
Throughout financial crises and recessions, central banks globally find themselves with new tools to combat deflationary pressures. One of these tools is Quantitative Easing (QE), which involves central banks pumping money into the economy and using it to buy financial assets such as government bonds. The primary goal is to increase the ease of credit circulation and drive down interest rates.
In this article, we will discuss what quantitative easing is and how it works. We will also explain why a central bank would choose to implement quantitative easing and look at examples of when it has been used in the past.
What is Quantitative Easing?
Quantitative easing (QE) is a monetary policy employed by governments and central banks to decrease interest rates, increase the money supply, or boost investment by buying government or corporate securities. The primary goal of QE is to lower interest rates and spur economic growth.
The term “quantitative easing” was first used in Japan in the 1990s but gained prominence in the 2000s when the U.S. Federal Reserve and other central banks used this strategy to respond to the 2008 financial crisis and Great Recession.
Unlike traditional monetary policy, which typically focuses on controlling interest rates, quantitative easing is an expansionary monetary policy usually done when short-term interest rates are at or near zero.
How Does Quantitative Easing Work?
Quantitative easing employs a mechanism where the money is scaled up to lower interest rates and stimulate the economy. Central banks do this by purchasing government or corporate securities or crediting commercial banks with additional reserves.
When a central bank announces its intention to engage in quantitative easing, it is essentially promising to purchase a certain amount of government or corporate debt. The purchase of these assets increases the supply of money and gives the economy a push. As supply increases, investor confidence and business activities also see a positive push.
Also Read: What Is Dynamic Bond Fund And Is It Worth Investing In?
Examples of Quantitative Easing
Quantitative easing has been used in the past to combat deflationary pressures in the economy and drive down interest rates. The Federal Reserve’s use of quantitative easing during the 2008 financial crisis was perhaps its most notable use of the policy.
Here are some of the noted examples when quantitative easing was employed:
1. The 2008 Housing Bubble Crisis
The Federal Reserve began using QE in late 2008 when the U.S. housing bubble peaked, and the global economy slowed down. By purchasing large quantities of mortgage-backed securities (MBS), the Fed could keep interest rates low, which helped prevent a larger economic downturn.
In addition, QE helped stabilise bond markets and reduce uncertainty about future interest rates, keeping investors from moving their money out of conservative investments into riskier ones.
The Federal Reserve purchased $1.7 trillion worth of U.S. Treasury and agency securities during the first two rounds of quantitative easing (QE1 and QE2), carried out between December 2008 and June 2010. This also kept the value of the U.S. dollar more or less stable, which helped other countries that relied on the currency for trade, such as China and Japan.
2. Eurozone Financial Crisis
Quantitative easing has been used extensively in the Eurozone since 2011, when the European Central Bank (ECB) first implemented QE1.
The ECB increased its balance sheet from €500 billion to €2 trillion between December 2011 and September 2016 with short-term loans for banks and long-term treasury purchases. Policymakers also announced plans for further stimulus measures at the end of 2015.
3. RBI Employing QE to Control Inflation
In India’s case, Quantitative Easing was employed after the crisis in 2008 to help stabilise the rupee. The Reserve Bank of India (RBI), (country’s central bank), reduced its key interest rate by several basis points between December 2008 and June 2009 to keep inflation under control, stop rupee depreciation and keep investor confidence high.
The basis point reduction was viewed as one of India’s central bank’s most extensive easing/cooling measures.
RBI’s decision to embark on QE helped stabilise the rupee and led to economic recovery.
4. Covid-19 Crisis
During the Covid crisis, the Fed and several other central banks cut their interest rates to boost economic growth, increase lending and revive their economies. Quantitative easing was done to encourage borrowing and spending to stimulate growth. The Feds also stated that they would be purchasing $500 billion in Treasury securities and $200 billion in government-guaranteed mortgage-backed securities.
How Does Quantitative Easing Affect Financial Markets?
Quantitative easing can improve the liquidity of the bond and stock markets by boosting the supply of government bonds and equities. This helps to improve the overall value of a country’s bond and stock market portfolio. This is especially important for governments that have a large amount of debt.
QE can also help to reduce uncertainty in the financial markets. When investors are unsure about what will happen next, they may be reluctant to invest money in new ventures or take out loans against their assets.
Quantitative easing can help to reduce this uncertainty by making it clear that there is enough liquidity in the markets.
QE encourages businesses and individuals to borrow and invest more money. This naturally increases the price value of shares and helps the balance sheet of companies grow. This, in turn, boosts the economy and helps rebalance the country’s portfolio.
Advantages of Quantitative Easing
Some of the advantages of quantitative easing are:
1. Can Lower interest Rates
The advantage of quantitative easing is that it can drive down interest rates, making it easier for businesses and consumers to borrow. This boost in borrowing activity can help the economy.
2. Increased Investment
Quantitative easing can increase investment activities by making it easier for companies to borrow. This increased investment can have positive effects on the economy as a whole.
3. Portfolio Rebalancing
QE gives the government more control over its financial situation. By injecting extra cash into the economy through bond purchases, the government can prevent deflation, maintain portfolio balance and keep prices stable.
4. Economic Boost
QE can give the economy a much-needed boost. By taking on more debt, the government can spend more money on infrastructure projects, tax cuts and increased social welfare payments. This can result in a stronger economy and higher employment rates.
Disadvantages of Quantitative Easing
However, there are a few drawbacks of QE as well:
1. Taper Tantrum
During the financial crisis, central banks around the world implemented a variety of monetary policy tools, including quantitative easing. As the crisis ended, central banks began to taper their quantitative easing programs. When the Federal Reserve started to taper its quantitative easing program in 2013, it led to a significant stock market sell-off in 2014 known as the Taper Tantrum.
The Federal Reserve’s decision to scale back quantitative easing led to a significant stock market sell-off in 2014. During the Taper Tantrum, U.S. stocks lost about 10% of their value, global stocks lost even more.
2. Currency Depreciation
Quantitative easing can cause inflation by increasing the money supply, which causes the currency’s value to depreciate. As a result, imported goods become more expensive, and exports become less expensive, making the entire exercise counterproductive.
3. Decrease in Value of Investments
When quantitative easing may drive up the price of assets, like stocks, its tapering, as mentioned above, can cause significant losses. Also, while QE tapering, a sudden spike in interest rates can tank investor confidence.
4. Long-term Effects
It’s important to remember that quantitative easing is a short-term solution to a long-term problem. QE, counterproductive to its existence, can have a significant inflationary effect on the economy and can increase the long-term interest rates.
QE can also make countries vulnerable to foreign currency attacks due to the expansion in the money supply. This can make it more difficult for governments to implement fiscal policy measures, as they will have to compete with other countries that are also printing money.
So, while QE can help drive down interest rates, increase money supply, and encourage investment, it cannot fix underlying problems.
Also Read: 10 Best-Performing Corporate Bonds In India (2022 Update)
Final Word
Quantitative easing is a monetary policy that central banks adopt to stimulate economies during recessions. QE aims to drive down interest rates, increase money supply, and encourage investment. The policy was famously employed during the 2008 housing crisis.
While quantitative easing may help ease financial crises, it can create many long-term problems for the economy, like hyperinflation and taper tantrums.
FAQs on Quantitative Easing
Ans. Quantitative easing (QE) is the process of increasing the money supply in the economy through the purchase of bonds, securities or other assets by a central bank.
Ans. Quantitative easing aims to increase the money supply in order to stimulate economic growth. The Understanding is that this increased supply will lead to heightened spending and investment, which should, in turn, lead to faster economic growth.
Ans. Yes, historically, quantitative easing has led to a decrease in interest rates. As the money supply increases because of QE, banks and individuals can borrow more money at decreasing interest rates.
Ans. Yes, quantitative easing has seen employment during the 2008 crisis, Eurozone crisis, and the latest during the Covid-19 pandemic. It has successfully managed to cushion the impact of these financial events.
Ans. Yes, during the 2008 recession, RBI employed QE to reduce inflation, stop rupee depreciation and encourage investments.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
