What is Quantitative Easing?
Quantitative easing (QE) is a monetary policy tool employed by central banks to stimulate economic activity, particularly during periods of low inflation or economic recession, when traditional methods like lowering interest rates are insufficient. It involves the large-scale purchase of financial assets, such as government bonds, corporate debt, or asset-backed securities, from commercial banks and other financial institutions. This action increases the prices of these assets and lowers their yields, thereby reducing long-term borrowing costs and boosting the money supply in the economy.
Mechanism of Quantitative Easing
When a central bank implements QE, it buys financial assets, which injects liquidity into the financial system. This process has several key effects:
- Lowering Yields: By purchasing long-maturity government bonds and other assets, central banks lower the yields on these securities. The boosted asset prices make borrowing cheaper for governments and private entities.
- Boosting Asset Prices: QE can increase the prices of various financial assets. As a result, households feel richer and spend part of their wealth gain.
- Increasing Money Supply: The injection of liquidity by freeing balance sheets from long duration assets can stimulate spending and investment.
Historical Use of Quantitative Easing
QE gained prominence following the 2007-2008 global financial crisis. Central banks around the world, including the Fed, the Bank of England, the Bank of Japan (BoJ), and the ECB, have used QE.
- U.S. Experience: The Federal Reserve implemented several rounds of QE from 2008 to 2014. It significantly expanded its balance sheet from $882 billion in December 2007 to $4.473 trillion in May 2017.
- International Comparisons: Other central banks, such as the BoJ and the ECB, have also employed QE extensively. For example, the Bank of Japan’s balance sheet was 88% of GDP in December 2016, and the European Central Bank’s was 34% of GDP.
Academic Literature and Effectiveness
The academic literature on QE is diverse and includes various perspectives on its effectiveness and implications.
Effectiveness Debates
- Central Bank vs. Academic Views: Central bank studies tend to find QE more effective in boosting output and inflation compared to academic studies. Central bank papers report larger effects of QE on both output and inflation, with QE being most effective in the U.S. in terms of raising both output and prices.
- Methodological Differences: The used methodologies drive a big part of the found effectiveness. Central bank studies often use models that are more aligned with the operational framework of monetary policy. In turn, academic studies may employ a broader range of models and assumptions.
Economic Logic and Implications
- Economic Logic: QE is based on the principle that by lowering long-term interest rates and increasing the money supply, it can stimulate economic activity. However, various factors, including the state of the economy, the level of interest rates, and the type of assets purchased influence its effectiveness.
- Qualitative vs. Quantitative Easing: Some researchers differentiate between quantitative easing (an increase in the central bank’s balance sheet) and qualitative easing (a shift towards less liquid and riskier assets). This distinction highlights that central banks may engage in both types of easing. The choice of which assets to buy can have different implications for financial stability and economic outcomes.
Criticisms and Future Directions
While many central banks use, it is not without criticisms. Some concerns include:
- Asset Price Inflation: QE can lead to asset price inflation, without real economic growth, and could thereby exacerbate wealth inequality.
- Risk of Inflation: There is a risk that excessive QE could lead to higher inflation if the economy recovers more quickly than anticipated.
- Size of Balance sheet: The accompanying increase in central bank balance sheets could be hard to reverse quickly. Consequently, more careful maneuvering could be required in the future. For example, when raising interest rates, central banks holding long term low yielding bonds incur an accounting loss. As a result, markets could question the willingness or credibility of central banks to raise rates.
Conclusion
Quantitative easing is a complex and multifaceted monetary policy tool that has been extensively used in recent years. Academic literature shows mixed results regarding its effectiveness. However, it is clear that QE can have significant impacts on financial markets and the broader economy. Understanding the nuances of QE, including its mechanisms, historical use, and the discussion in the literature, is crucial for policymakers and financial market participants. The role and effectiveness of QE will remain a subject of ongoing research and debate.
