Quantitative easing (QE) is a form of monetary policy that central banks use to stimulate the economy. As part of this strategy, central banks purchase assets like mortgage-backed securities and government bonds.
Through the use of QE, central banks can increase the money supply. They do this as counter-cyclical measure to provide liquidity to the economy during an economic crisis.
Quantitative easing is a relatively recent and exotic form of monetary policy. The main way central banks like the Federal Reserve conduct monetary policy is by setting short-term interest rates in the form of the Federal Funds Rate.
The Federal Funds Rate is the interest rate at which banks provide overnight loans to each other. All banks need to keep a certain amount of reserves at the Federal Reserve.
When a bank holds more reserves than required at the Federal Reserve, it can provide overnight loans to other banks that are in need of liquidity. The Federal Funds Rate is the target rate at which banks provide these overnight loans to each other.
The Federal Funds Rate is set by the Federal Reserve and used to control the money supply. When the Federal Funds Rate is low, other interest rates like mortgages and interest on bank deposits remain low as well.
Under the fractional reserve banking system, banks lend money into existence when they provide a loan. For example, if you apply for a mortgage, the bank doesn’t lend you money it owns.
It creates money that didn’t exist before. This means, by setting short-term interest rates, the Federal Reserve can influence how much money is circulating in the economy.
When interest rates are low, taking out a loan is more attractive for individuals and businesses. In low-interest environments, borrowing increases and new money enters the economy through the fractional reserve banking system.
On the other hand, when interest rates are high, borrowing slows down. This results in less new money entering the economy.
Until the Global Financial Crisis of 2008, the Federal Reserve had never used quantitative easing to intervene in the economy. The primary way the Federal Reserve conducted monetary policy was by setting the Federal Funds Rate.
Other central banks, such as the Bank of Japan, already deployed QE programs before the Global Financial Crisis. In the late 1980s, the Bank of Japan started implementing Keynesian counter-cyclical policies.
The term quantitative easing was coined by German economist Richard Werner after he visited Japan in 1995.[1] Werner, Richard: Keiki kaifuku, ryōteki kinyū kanwa kara (How to Create a Recovery through ‘Quantitative Monetary Easing’) (1995). He suggested that Japan use this strategy to stimulate its economy.
In response to the Asian Financial Crisis of 1997, the Bank of Japan launched its first QE program in 2001. It purchased government bonds, corporate bonds and stocks to stimulate the Japanese economy.[2] Bank of Japan: “New Procedures for Money Market Operations and Monetary Easing” Accessed April. 8, 2022. At the time, this was unconventional and unthinkable in a country like the United States.
This changed in 2008 when the Federal Reserve launched its first quantitative easing program in response to the Global Financial Crisis. They named the first program QE1.
As part of QE1, the Federal Reserve announced the purchase of $100 billion in obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks.[3] Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities … Continue reading These government-sponsored enterprises financed home mortgages in the United States. But they faced bankruptcy when the United States Housing Bubble burst in 2008.
Through its QE program, the Federal Reserve propped up the mortgage and housing markets and provided financial institutions on the verge of bankruptcy with money.
The Federal Reserve also announced the purchase of $500 billion worth of mortgage-backed securities.
In March 31, 2010 QE1 terminated. The Federal Reserve purchased a total of $1.5 trillion in bonds, including $1.2 trillion in US Agency debt and mortgage backed securities and $300 billion in government bonds.
At the time, the QE program was highly controversial. Fears of inflation and outrage over the government bailing out banks and other financial institutions that had speculated and engaged in risky practices reverberated throughout the economy.[4] Chicago Tribune: “Who will bail out American families?” Accessed April. 8, 2022.
It contributed to the Occupy Wall Street movement that criticized wealth inequality in the United States.
Millions of Americans lost money during the Global Financial Crisis. But they didn’t receive much financial help from the government. Only “Too Big To Fail” financial institutions got a bailout.
In 2010, the Federal Reserve announced its second quantitative easing program known as QE2.
To provide additional support to the economy after the Global Financial Crisis, the Federal Reserve purchased an additional $827 billion worth of government bonds.[5] Federal Reserve: “FOMC statement” Accessed April. 8, 2022.
The Federal Reserve started another round of quantitative easing between 2012 and 2014 known as QE3.[6] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April. 8, 2022. Several years later, in 2017, the Federal Reserve announced that it would reduce its balance sheet.[7] Federal Reserve: “FOMC issues addendum to the Policy Normalization Principles and Plans” Accessed April. 8, 2022.
The balance sheet reduction, also known as quantitative tightening, was challenging. In 2019, the Federal Reserve abandoned its quantitative tightening efforts.
Around the time when the Federal Reserve planned to further reduce its balance sheet, the world experienced another economic crisis.
This time a global pandemic caused the crisis and not subprime mortgages.
As the economy grind to a halt and the world went into lockdown, the Federal Reserve started its fourth quantitative easing program.
This time, the Fed announced it would purchase up to $700 billion worth of government bonds and mortgage-backed securities. It also lowered the Federal Funds Rate to zero to flood the economy with liquidity.[8] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April. 8, 2022.
On March 23, 2020, the Federal Reserve made its asset purchases open-ended, saying it would buy as many assets as necessary to support the economy.[9] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April. 8, 2022. It effectively ended up purchasing $120 billion worth of assets per month.
This was the largest-scale quantitative easing program ever launched in the United States. In late 2021, the Fed began tapering its balance sheet again.[10] Federal Reserve: “Federal Reserve issues FOMC statement” Accessed April. 8, 2022. And as of beginning of 2022, it announced several interest rate hikes and a new round of quantitative tightening.
While quantitative easing used to be an unconventional and exotic form of monetary policy, it became a frequently used tool after the Global Financial Crisis of 2008.
One of the reasons for this is that when interest rates are already at zero or close to zero percent, the Federal Reserve can’t rely on short-term interest rates alone to expand the money supply.
Since 1981, the Federal Funds Rate has been in a downward trend. After 2008, the Federal Funds Rate stayed close to zero percent. Between 2016-2019 the Federal Funds Rate increased to 2.44%. This is still relatively low when we compare it to the 5.21% in 2007 or the 6.47% in 2000.[11] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April. 8, 2022.
When the Federal Funds Rate is already low or close to zero percent, strategies like quantitative easing allow the Federal Reserve to provide the economy with more liquidity.
When lowering short-term interest rates isn’t an option anymore, or would result in negative interest rates, quantitative easing provides another way to expand the money supply.
Quantitative easing tends to push up prices of government bonds. Due to how bonds work, when prices increase, interest rates decrease.
This is why large-scale quantitative easing programs have a similar effect as lowering the Federal Funds Rate. However, buying government bonds allows central banks to influence long-term interest rates as well.
When central banks purchase significant amounts of government bonds, this increases demand for these bonds and bids up their prices. As bond prices increase, and bond holders receive the same fixed interest payment, the interest rates of government bonds drop.
The 10-year Treasury acts as the bedrock of the financial system. It’s the risk-free rate against which all other assets are measured.
When the prices of 10-year Treasuries increases due to quantitative easing, and their interest rates subsequently drop, this allows the United States government to borrow money more cheaply.
Pushing down mid and long-term interest rates of government bonds is usually a side effect of quantitative easing and not its main purpose. When central banks purposely buy or sell assets to influence medium and long-term interest rates, this is known as yield curve control.
Quantitative easing and yield curve control are similar strategies. They both include buying government bonds. But they have different objectives.
As mentioned earlier, the Bank of Japan engaged in counter-cyclical monetary policy since the early 1980s. However, after the Asian Financial Crisis of 1997, a more aggressive approach of quantitative easing was implemented in Japan.
The Bank of Japan engaged in 15 years of quantitative easing, starting in 2001.[12] Bank of Japan: “New Procedures for Money Market Operations and Monetary Easing” Accessed April. 8, 2022.
The Swiss National Bank deployed a quantitative easing program in response to the Global Financial Crisis in 2008. By the end of the quantitative easing program, the Swiss National Bank owned more assets than the entire annual economic output of Switzerland.[13] Jordan J., Thomas et al.: Ten Years’ Experience with the Swiss National Bank’s Monetary Policy Strategy, in: Swiss Society of Economics and Statistics, vol. 149, pp. 9ff. (2010).
The ratio of assets owned by the Swiss National Bank compared to the country’s GDP made the Swiss quantitative easing program one of the largest in the world.
The Bank of England, European Central Bank and Sveriges Riksbank of Sweden deployed major Quantitative Easing programs as well in response to the Global Financial Crisis.
There are different opinions on whether quantitative easing causes inflation or not. For example, the quantitative easing program deployed by the Bank of Japan didn’t cause inflation.[14] World Bank: “Inflation, consumer prices (annual %) – Japan” Accessed April. 8, 2022.
A lot of people feared inflation or even hyperinflation when the Federal Reserve started its QE1 program. But inflation stayed relatively low after the Global Financial Crisis in 2008.[15] Federal Reserve Bank of St. Louis: “Consumer Price Index: All Items for the United States” Accessed April. 8, 2022. The massive expansion of the money supply didn’t cause hyperinflation in the United States.
Quantitative easing is only inflationary if the money created by the Federal Reserve ends up in the broader economy.[16] Lyn Alden: “Quantitative Easing, MMT, and Inflation/Deflation: A Primer” Accessed April. 8, 2022.
During the United States Housing Bubble, banks and other financial institutions bought and sold derivatives that turned out to be worthless. Many banks had these worthless derivatives on their balance sheets.
During the Global Financial Crisis, the Federal Reserve purchased these assets and resupplied struggling banks and financial institutions with money.
This rebalanced the base money supply. Instead of going bankrupt for holding derivatives that proved to be worthless, the Federal Reserve took these assets on its own balance sheet. It bought them from banks and financial institutions when nobody else wanted to buy and hold them anymore.
Banks were made whole again, resupplying them with liquidity after many derivatives became worthless. However, the broad money supply didn’t grow in this case.
This doesn’t mean that quantitative easing doesn’t cause inflation in general. After the Federal Reserve’s QE4 program, inflation reached its highest reading in over 40 years.[17] Federal Reserve Bank of St. Louis: “Consumer Price Index: All Items for the United States” Accessed April. 8, 2022.
While many economists and politicians attribute this to supply chain issues or the geopolitical situation, critics of the QE4 program argue that it was inflationary. This time, quantitative easing wasn’t used to rebalance the base money supply after assets held by banks became worthless.
Critics of QE4 believe that it resulted in an expansion of the broad money supply. In other words, the money created by the Federal Reserve ended up in the economy.
One major difference between QE1 and QE4 is that in 2008, banks and financial institutions received a bailout. This was incredibly unpopular at the time. During the Covid-19 pandemic in 2020, the government took a different approach.
Additional to the monetary policy conducted by the Federal Reserve, Americans received stimulus checks as part of the government’s fiscal policy. But fiscal policy and monetary policy are intertwined.
When the Federal Reserve buys government bonds through its QE programs, and the government spends this money on stimulus checks, this money ends up in the broader economy.[18] Lyn Alden: “Quantitative Easing, MMT, and Inflation/Deflation: A Primer” Accessed April. 8, 2022.
This is one explanation why QE1 didn’t cause inflation while some argue that QE4 did. However, whether quantitative easing is inflationary or not is debated. Mainstream economists and politicians reject the theory that quantitative easing or government spending are responsible for the heightened inflation in the Untied States in 2022.[19] Fox Business: “Biden, Pelosi push back after inflation blamed on Dems’ spending: ‘I’m sick of this stuff’” Accessed April. 8, 2022.
Rather than viewing inflation as a purely monetary phenomenon, they attribute increases to inflation to external factors like supply chain disruptions, rising oil prices and other factors that drive up prices.
Critics of quantitative easing view it as outright money printing. For them, central banks are simply creating money out of thin air. Some argue that using terms like quantitative easing obfuscates the true nature of money printing.[20] Haslam, Philip & Lamberti, Russell: When Money Destroys Nations. How Hyperinflation Ruined Zimbabwe, How Ordinary People Survived, and Warnings for Nations that Print Money, pp. 112ff. (2015).
Others criticize QE as a tool that increases wealth and income inequality. When central banks print money to stimulate the economy, those that receive the money, such as governments, banks and “Too Big To Fail” financial institutions, are benefiting while the general public is on the losing end.
In cases where quantitative easing leads to inflation, critics see it as a transfer of purchasing power from the general public to the government and institutions closely linked to it.
Quantitative easing props up asset prices of government bonds, and more indirectly stocks and real estate. This form of asset price inflation mostly benefits the wealthy. Average citizens that have no investible assets and live paycheck to paycheck don’t benefit or are even negatively impacted by quantitative easing.
Some people also criticize quantitative easing for its environmental impact. When central banks purchase corporate bonds additionally to government bonds, they might be indirectly subsidizing companies that engage in practices that have a negative effect on climate change.[21] Corporate Europe Observatory: “ECB cash injections for polluters must stop, 70 NGOs demand” Accessed April. 8, 2022.
Others view quantitative easing as ineffective or argue that it’s impossible to distinguish between the effects of quantitative easing and lowering interest rates.
When central banks lower interest rates and engage in quantitative easing at the same time, it’s difficult or impossible to know which strategy is responsible for economic recovery.
For example, after the Swiss National Bank engaged in its aggressive quantitative easing program, the economy recovered. But it was unclear if the recovery could be solely attributed to quantitative easing or if the economy recovered by itself or due to other factors.[22] Jordan J., Thomas et al.: Ten Years’ Experience with the Swiss National Bank’s Monetary Policy Strategy, in: Swiss Society of Economics and Statistics, vol. 149, pp. 9ff. (2010).
On the other hand, many mainstream economists view quantitative easing as a helpful tool for crisis intervention. According to them, quantitative easing neither causes inflation nor poses a moral or environmental hazard.
Quantitative easing, as well as its effects, remains a highly debated and controversial subject. And it’s likely to stay a topic of heated discussions in the future.