What Is Quantitative Easing? How Does QE Work? – Forbes Advisor

Quantitative easing—QE for short—is a monetary policy strategy used by central banks like the Federal Reserve. With QE, a central bank purchases securities in an attempt to reduce interest rates, increase the supply of money and drive more lending to consumers and businesses. The goal is to stimulate economic activity during a financial crisis and keep credit flowing.

What Is Quantitative Easing (QE)?

When a central bank decides to use QE, it makes large-scale purchases of financial assets, like government and corporate bonds and even stocks. This relatively simple decision triggers powerful outcomes: The amount of money circulating in an economy increases, which helps lower longer-term interest rates. This lowers the cost of borrowing, which spurs economic growth.

By buying longer maturity securities, a central bank is aiming to lower longer-term market interest rates. Contrast this with one of the main tools used by central banks: Interest rate policy, which targets shorter-term market interest rates.

When the Federal Reserve adjusts its target for the federal funds rate, it’s seeking to influence the short-term rates that banks charge each other for overnight loans. The Fed has used interest rate policy for decades to keep credit flowing and the U.S. economy on track.

When the fed funds rate was cut to zero during the Great Recession, it became impossible to reduce rates further to encourage lending. Instead, the Fed deployed QE and began purchasing mortgage-backed securities (MBS) and Treasuries to keep the economy from freezing up.

QE Sends a Powerful Message to Markets

Central banks like the Fed send a strong message to markets when they choose QE. They are telling market participants that they’re not afraid to continue buying assets to keep interest rates low.

“It’s a powerful signal that the Fed wants to stimulate economic growth and that is an influential force on capital markets and asset prices,” says Bill Merz, head of fixed income research at U.S. Bank Wealth Management in Minneapolis. “That signaling effect so far has been the most influential component of quantitative easing.”

QE is deployed during periods of major uncertainty or financial crisis that could turn into a market panic. It’s intended to both address immediate concerns in the financial markets and stave off an even worse crisis, says Luke Tilley, chief economist at Wilmington Trust in Philadelphia and a prior economic advisor at the Federal Reserve Bank of Philadelphia.

“One goal is to put out the house fire and the other is to use the fire hose to flood the system with liquidity so you don’t have a financial crisis,” he says.

How Does Quantitative Easing Work?

Quantitative easing works by making large-scale asset purchases. In response to the coronavirus pandemic, for example, the Fed has begun purchasing longer-maturity Treasuries and commercial bonds. Here’s how the simple act of buying assets in the open market changes the economy (mostly) for the better:

• Fed buys assets. The Fed can make money appear out of thin air—so-called money printing—by creating bank reserves on its balance sheet. With QE, the central bank uses new bank reserves to purchase long-term Treasuries in the open market from major financial institutions (primary dealers).
• New money enters the economy. As a result of these transactions, financial institutions have more cash in their accounts, which they can hold, lend out to consumers or companies, or use to buy other assets.
• Liquidity in the financial system increases. The infusion of money into the economy aims to prevent problems in the financial system, such as a credit crunch, when available loans decrease or the criteria to borrow money drastically increase. This ensures the financial markets operate as normal.
• Interest rates decline further. With the Fed buying billions worth of Treasury bonds and other fixed income assets, the prices of bonds move higher (greater demand from the Fed) and yields go lower (bondholders earn less). Lower interest rates make it cheaper to borrow money, encouraging consumers and businesses to take out loans for big-ticket items that could help spur economic activity.
• Investors change their asset allocations. Given the now-lower returns on fixed income assets, investors are more likely to invest in higher-returning assets—like stocks. As a result, the overall stock market could see stronger gains because of quantitative easing.
• Confidence in the economy grows. Through QE, the Fed has reassured markets and the broader economy. Businesses and consumers may be more likely to borrow money, invest in the stock market, hire more employees and spend more money—all of which helps to stimulate the economy.

The Downsides of QE

Implementing QE comes with potential downsides, and its impact is not universally beneficial to everyone in the economy. Here are some of the dangers:

QE May Cause Inflation

The biggest danger of quantitative easing is the risk of inflation. When a central bank prints money, the supply of dollars increases. This hypothetically can lead to a decrease in the buying power of money already in circulation as greater monetary supply enables people and businesses to raise their demand for the same amount of resources, driving up prices, potentially to an unstable degree.

“The biggest criticism of QE is that it might cause rampant inflation,” says Tilley. But that doesn’t always happen. For instance, inflation never materialized in the 2009-2015 period when the Fed implemented QE in response to the financial crisis.

QE Isn’t Helpful for Everyone, May Cause Asset Bubbles

Some critics question the effectiveness of QE, especially with respect to stimulating the economy and its uneven impact for different people. Quantitative easing can cause the stock market to boom, and stock ownership is concentrated among Americans who are already well-off, crisis or not.

“There is a healthy debate in academia and capital markets about the efficacy of quantitative easing,” Merz says, adding that in his observation, academic papers are “split down the middle’ on whether this policy does what it’s intended to do. “The two primary critiques are that it might not work and we have trouble proving that it does.”

That said, Michael Winter, the founder and chief executive officer of Leatherback Asset Management, notes that quantitative easing has been “extremely effective” in stabilizing and eventually increasing asset prices in both the fixed income and equity markets. And when the market rebounds quickly, as it did following the bear market of 2020, the question becomes when do we say enough is enough?

By lowering interest rates, the Fed encourages speculative activity in the stock market that can cause bubbles and the euphoria can build upon itself so long as the Fed holds pat on its policy, Winter says. “This is a confidence game; market participants think the Fed has their back and as long as they do, there’s limited fear,” he says.

QE May Cause Income Inequality

A final danger of QE is that it might exacerbate income inequality because of its impact on both financial assets and real assets, like real estate. “It has benefited those who do well when asset prices go up,” Winter says.

This potential for income inequality highlights the Fed’s limitations, Merz says. The central bank doesn’t have the infrastructure to lend directly to consumers in an efficient way, so it uses banks as intermediaries to make loans. “It is really challenging for the Fed to target individuals and businesses that are hardest hit by an economic disruption, and that is less about what the Fed wants to do and more about what the Fed is allowed to do,” he says.

“I have likened it to standing at the edge of a swimming pool and holding a pitcher of water that is dyed purple, and then dumping that water into the swimming pool,” Tilley says. “It’s not going to take any time before you don’t know where the purple water goes.” In other words, once QE money is on the balance sheets of primary dealers, it may not benefit everyone in the economy as intended.

Historical Examples of Quantitative Easing

The Bank of Japan has been one of the most ardent champions of quantitative easing, deploying this policy for more than a decade. The European Central Bank and the Bank of England also used QE in the wake of the global financial crisis that began in 2007.

The Fed began using QE to combat the Great Recession in 2008, and then-Fed Chair Ben Bernanke cited Japan’s precedent as both similar and different to what the Fed planned to do. In three different rounds, the central bank purchased more than $4 trillion worth of assets between 2009 and 2014.

In the first rounds of QE during the financial crisis, Fed policymakers pre-announced both the amount of purchases and the number of months it would take to complete, Tilley recalls. “The reason they would do that is it was very new, and they didn’t know how the market was going to react,” he says.

By the third round of QE in 2013, the Fed moved away from announcing the amount of assets to be purchased, instead pledging to “increase or reduce the pace” of purchases as the outlook for the labor market or inflation changes.

“During the financial crisis, it was relatively uncharted territory and so the Fed was more cautious about messaging and more cautious about the amounts of purchases and the duration of their policies,” Merz adds. “Once some of the concerns cited by critics in the market didn’t come to fruition, at that point the Fed was emboldened to consider expanding the program and doing it in larger sizes.”

QE and the Coronavirus Crisis

Building on the lessons of the Great Recession, the Fed relaunched quantitative easing in response to the economic crisis caused by the Covid-19 pandemic. Policymakers announced plans for QE in March 2020—but without a dollar or time limit.

The unlimited nature of the Fed’s pandemic QE plan was the biggest difference from the financial crisis version. Market participants got comfortable with this new approach after three rounds of QE during the financial crisis, which gave the Fed flexibility to keep purchasing assets for as long as necessary, Tilley says.

Winter notes that the stock market took off in response to the new plan. The S&P 500 surging nearly 68% from its March 2020 lows through the end of the year, at least in part because of the safety net of QE.

Statements from policymakers reinforced that it would support the economy as much as possible, Merz says. “When you have an institution as powerful as the Fed throwing the kitchen sink at supporting the recovery and saying again and again they will support this as long as it works, we should listen,” he says.

Does QE Work?

Yes and no say Tilley, Winter, and Merz. The policy is effective at lowering interest rates and helps to boost the stock market, but its broader impact on the economy isn’t as apparent. And what’s more, the effects of QE benefit some people more than others, including borrowers over savers and investors over non-investors.

QE has been “hugely effective” in the early parts of both the most recent coronavirus crisis and the financial crisis, according to Tilley. “In March 2020, the illiquidity in the Treasury market was striking; it was scary,” he says.

But once the market has stabilized, the risk of QE is that it could create a bubble in asset prices—and the people who benefit most may not need the most help, Winter says. And the cost to this policy is significant in that it adds to the imbalances in income inequality in this country, he adds.

And there are lingering concerns about the potential of relying too heavily on QE, and setting expectations both within the markets and the government, Merz says. “An explosion in the money supply could harm our currency and that’s the ultimate fear behind QE that hasn’t happened in a dramatic way,” he adds.

What’s clear is that there are pros and cons to QE, and even evaluating its effects is difficult, Stephen Williamson, a former economist with the Federal Reserve Bank of St. Louis, concluded in a paper. “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case that QE is actually detrimental,” he writes.