Quantitative easing (QE) is a monetary policy tool in which a central bank attempts to stimulate growth in the economy by buying bonds or other financial assets in the open market.
When the central bank purchases assets, the money they’ve spent gets released into the market, increasing the money supply in an economy. QE is an unconventional monetary policy tool that’s usually used by a central bank when traditional tools–like lowering interest rates–are no longer effective or an option.
In the U.S., the central bank is the Federal Reserve. The Fed notably conducted multiple rounds of QE after the 2008 financial crisis. The U.S. central bank also embarked on a QE program in 2020 when quarantine measures were put in place due to the Covid-19 pandemic.
Read more below about how quantitative easing works, how QE has been applied, and its pros and cons.
How Does Quantitative Easing Work?
Quantitative easing makes it easier for businesses to borrow money from banks, by essentially lowering the cost of borrowing money.
When the Federal Reserve purchases securities from other banks, it issues a credit to the bank’s reserves, thereby figuratively increasing the money supply. No funds actually change hands in a QE program. The funds used to purchase the securities are essentially created out of thin air as a credit. Hence, QE is often referred to as “printing money” since the central bank is boosting the fiat currency supply.
When the Fed purchases Treasuries from the government, this also keeps Treasury yields low by increasing the demand for them. When Treasury yields stay low, long-term interest rates remain low, which can make it easier for consumers to take out loans for a car, house, or other types of debt.
Banks are required to have a certain amount of money on hand each night when they close their books. This is called the bank reserve requirement. QE gives banks more than they need to hit this reserve requirement. When banks have extra money, they lend it out to other banks to make a profit. This can also help stimulate the economy.
In addition to making it easier for banks to give out loans, QE keeps the value of the U.S. dollar lower, which in turn lowers the cost of exports and makes stocks attractive to foreign investors. All of these factors can help to keep the economy running during challenging times.
When Low Interest Rates Aren’t Enough
While Congress controls government spending and tax rates–what’s known as fiscal policy–the Federal Reserve controls short-term interest rates, which are the main tool used to prevent or lower the impacts of a recession–a system known as monetary policy.
More specifically, the Fed adjusts the rate that banks have to pay to one another to loan money that is held in Fed accounts. If banks can borrow money at a lower rate, they in turn can lend money to their customers at a lower rate.
Central banks have long preferred to lower short-term interest rates to expand the economy and encourage more spending. Similarly, the Federal Reserve raises interest rates to slow inflation. But when interest rate cuts aren’t enough to stimulate the economy, as is now the case, quantitative easing is sometimes used as a last resort.
One limitation on interest rates is that they can’t practically be lowered to less than zero. Technically, negative interest rates are possible, but this would mean that banks would actually be paying people to borrow money, rather than the other way around.
When interest rates fall to near zero, and banks, corporations, and individuals hoard money, this results in a lack of liquidity in the market. Quantitative easing can help release money back into the market. The asset purchases will take place over the course of several months. The goal is to make sure that businesses have sufficient funds to lend to other businesses throughout the economic downturn.
Does Quantitative Easing Cause Inflation?
One of the biggest fears about quantitative easing is that it will cause too much inflation, or price increases. In such a scenario, inflation would occur because there’s a lot of money in the system.
Some economists argue that if the money supply increases quickly, it increases demand as more people have ample money to spend. That, in turn, can raise prices rapidly or encourage reckless financial decisions.
Some degree of inflation is healthy and normal. For instance, in the U.S., the Federal Reserve targets an inflation rate of 2%. But inflation rates that are too high can be painful for consumers. For instance, during the 1970s, the inflation rate averaged 7% and hit double-digit levels in 1974 and 1979, causing the prices of some goods–most notably oil–to skyrocket.
Did QE Cause Inflation in the U.S.?
After the 2008 crisis however, the U.S. economy didn’t experience significant inflation, even though the Federal Reserve conducted multiple rounds of QE. This has been attributed by some market observers to banks stockpiling the extra liquidity they received. So instead of lending out the extra money, the banks held onto it.
However, some in the market have argued that the QE done in 2020 due to the Covid-19 pandemic could cause inflation due to banks hanging on to less excess reserves.
In other words, they lent out the extra liquidity they got from QE, injecting that money into the economy. QE, in addition to the Covid-19 stimulus packages done on the fiscal policy side, has caused some to worry about inflation risk again. However, in 2020, Fed Chair Jerome Powell said the central bank would tolerate inflation over 2% “for some time.”
Past Examples of Quantitative Easing
A relatively new strategy, quantitative easing has been used a number of times over the past 20 years, with varying degrees of success.
Quantitative Easing in Japan
The first example of an advanced first-world country implementing a quantitative easing program was Japan in 2000-2006. Japan entered into a recession following the Asian Financial Crisis of 1997.
The Bank of Japan bought private debt and stocks through the QE program, but the program didn’t result in the stimulus they had hoped for. Japan’s GDP fell from $5.45 trillion to $4.52 trillion between 1995 and 2007.
Japan also used QE in 2012 when Prime Minister Shinzo Abe was elected and sought to stimulate the economy.
Quantitative Easing in U.S.
A few rounds of quantitative easing took place throughout the financial crisis from 2008 to 2011.
The most successful example of QE was the $2 trillion stimulus enacted by the U.S. in 2008, despite the fact that it doubled the national debt from $2.1 trillion to $4.4 trillion in just a few years. Although many feel that the QE program helped get the U.S. and global economy through the 2009 recession, this topic has been debated and is hard to quantify.
Some critics argue that banks actually held on to much of the excess money they received through the QE program rather than lending it out, so the program didn’t exactly have the desired effect. However, QE helped to remove subprime mortgages from bank balance sheets and bring the housing market back.
Quantitative Easing in Switzerland
During the 2008 financial crisis, the Swiss National Bank also implemented a QE program. In terms of its ratio to GDP, the Swiss program was the largest ever enacted in the world.
Despite this overwhelming effort that resulted in some economic growth, Switzerland didn’t reach its inflation targets after the use of QE.
Quantitative Easing in U.K.
More recently, in 2016, the Bank of England launched a QE program worth 70 billion pounds to help alleviate economic concerns about Brexit.
Between 2016 and 2018, business investment grew in the U.K., but it was still growing at a slower rate than it had been in previous years. Economists have not been able to confirm whether growth would have been even slower without the QE program.
Pros and Cons of Quantitative Easing
While QE programs can help stimulate a struggling economy, they have some downsides, and there are reasons they are used as a last resort.
Pros of Quantitative Easing
• QE programs make it easier for businesses to take out loans.
• The influx of money into the market can help keep the economy flowing and release liquidity traps.
• Low interest rates make it easier for consumers to take out loans for cars, homes, and other borrowing needs.
• QE can be an important tool during a financial crisis in order to avert recession, or even severe economic depression.
Cons of Quantitative Easing
• Increasing the supply of money can lead to inflation.
• Stagflation can occur if the QE money leads to inflation but doesn’t help with economic growth. The Fed can’t force banks to lend money out and it can’t force businesses and consumers to take out loans.
• QE can devalue the domestic currency, which makes production and consumer costs higher.
• As a relatively new economic concept, there isn’t data and consensus about whether QE is effective.
What If QE Doesn’t Work?
Previous QE programs implemented by Japan, Switzerland, and the U.K. have not managed to reach the stimulus goals they set out to achieve. However, the QE program enacted in the U.S. during the 2009 recession helped to revive the housing market, stimulate the economy, and restore trust in banks. It didn’t cause rampant inflation as many feared it would.
As a relatively new strategy, there isn’t enough data to confirm whether QE is effective. In fact, there isn’t even agreement about how exactly it’s supposed to work.
Flattening the Yield Curve
Economists have a theory that quantitative easing will work by flattening the yield curve, which is a graph curve that displays the variation of interest rates according to their term of maturity. When the Fed purchases long-term Treasuries, their yield goes down and their prices go up.
This results in the yields of corporate bonds and long-term mortgages going down as well. Lower rates encourage home construction, corporate investment, and other activities that stimulate the economy. Although this sounds good in theory, the issue in the current economy is that the yield curve is already pretty flat.
A QE program might stimulate the economy for a short amount of time, but it could also lose its effectiveness. If this happens, the government can also turn to fiscal policy, or government spending, to further put money into the economy.
Sometimes QE and government spending can blur together, if the Fed purchases government bonds that are issued to fund government spending.
Some economists also believe that by signaling to the world that the Fed is serious about stimulating the economy, this will help create economic growth and spending and make consumers confident about making purchases. Whether this is true is yet to be seen in the current global situation.
Quantitative easing is an unconventional monetary policy tool that central banks can use when faced with weak or nonexistent growth. Central banks typically resort to measures like QE when more conventional monetary policy tools, such as lowering interest rates, are no longer effective or not enough to stimulate an economy.
The way QE works is by the central bank buying financial assets from commercial banks or other private institutions. The purchases of the assets give banks additional liquidity–money they can use to make loans to other banks, businesses or everyday people. These groups can in turn spend the borrowed funds on homes, cars, goods or services.
QE is a relatively new phenomenon, but they became more common after the 2008 financial crisis, when multiple central banks around the world resorted to asset purchases to boost economic growth.
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