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What is Quantitative Easing?

April 14, 2020 · 7 minute read

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What is Quantitative Easing?

As the world continues to navigate the coronavirus pandemic, governments and central banks are considering every possible option for keeping the economy afloat.

Even before the outbreak of the new disease, a process called quantitative easing was being considered to help an already flailing world economy.

In 2019 the Federal Reserve lowered interest rates three times in an attempt to keep the economy expanding. It’s been 11 years since the last economic recession, but in just a few months, the markets have collapsed as a result of the pandemic.

Now, unprecedented and uncommon economic measures, including quantitative easing, are being considered to mitigate the global crisis.

What is quantitative easing, and does it work?

Quantitative easing (QE) is a process of economic expansion in which a Central Bank buys existing government bonds and long-term securities to increase the supply of money in the open market and encourage investment and lending.

When the bank purchases these assets, the money they’ve spent gets released into the market.

In the U.S., this central bank is the Federal Reserve. Although it was created by Congress in 1913, the Federal Reserve is separate from the government and runs as an independent bank.

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.

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. Banks that have over $127.5 million in net transactions must hold 10% in cash or at the Federal Reserve bank.

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 Interest Rates Aren’t Enough

While Congress controls government spending and tax rates, the Federal Reserve controls short-term interest rates, which are the main tool used to prevent or lower the impacts of a recession.

More specifically, the Fed adjusts the rate that banks have to pay to one another to loan money that is held in Federal Reserve 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.

On March 15, 2020, the Federal Reserve lowered interest rates nearly to zero, with a target between 0% and 0.25%. This is down from a previous rate of 1% to 1.25%.

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 from this type of liquidity trap back into the market.

Following the recent interest rate slash, the Federal Reserve also announced the launch of a $700 billion quantitative easing program in the United States. The Fed is buying $500 billion in Treasuries and $200 billion in agency-backed mortgage securities.

These 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 ongoing coronavirus pandemic. The current QE program may total $1.5 trillion in asset purchases over time.

Despite these attempts, the market’s initial response to the Federal Reserve’s actions were negative, as the stock market continued to fall after the announcement.

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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.

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.

United States

A few rounds of quantitative easing took place throughout the financial crisis from 2008 to 2011, both in the U.S. and in the U.K.

The most successful example of QE was the $2 trillion stimulus enacted by the U.S. in 2008, despite that fact that it doubled the Federal 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.

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 helped to bring the housing market back.

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.

United Kingdom

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.

The 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:

•   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.

Cons:

•   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.

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.

Staying Up to Date on the Economy

These are unprecedented times for the entire world. Every country, business, and individual is taking things day by day, and the news can change rapidly.

It’s important to keep track of what’s going on in the economy, as it can affect jobs, investments, loans, and so much more.

A great tool for staying up to date on market news is by downloading the SoFi app. Download it to read all the latest headlines and follow familiar (and not-so-familiar) stocks and companies.

The SoFi app allows users to organize investments with SoFi Invest® and financial information in one easy-to-access app.

If users want to talk to an expert about their financial situation, SoFi has a team of financial planners available to answer questions and help with financial goals.

Stay up to date with the markets by downloading the SoFi app.


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