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What Is Quantitative Easing?

World · September 17, 2023 · Marcus Vale · 5 min

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Quantitative easing is a tool central banks use to support the economy by creating new money and buying financial assets. Here is how it works, why it is used, and the debate over its effects.

For most of modern history, the main lever a central bank pulled to steer the economy was the interest rate: raise it to cool things down, cut it to warm them up. But what happens when rates are already close to zero and the economy still needs help? The answer many central banks reached for was quantitative easing, a tool that was once obscure and is now a familiar part of the financial world. Here is what it is, how it works, why it is used, and why it remains controversial.

What it is

Quantitative easing, usually shortened to QE, is a monetary policy tool in which a central bank creates new money electronically and uses it to buy financial assets, most often government bonds, in order to support the economy. The aim is to lower longer-term interest rates and increase the amount of money circulating in the financial system, encouraging spending and investment when conventional rate cuts have run out of room.

The phrase sounds technical, but the core idea is straightforward. The central bank conjures money into existence with a few keystrokes, then spends it buying assets from banks, pension funds and other investors. Those sellers end up with cash instead of bonds, and that cash, the hope goes, flows into the wider economy.

Why central banks use it

A central bank's usual tool is the short-term interest rate, often called the base rate or policy rate. Cutting it makes borrowing cheaper and saving less rewarding, nudging households and businesses to spend and invest.

The problem is that rates cannot fall far below zero before the tool loses its bite. When a central bank has already cut to near zero and the economy still needs support, perhaps during a deep downturn or a crisis, it is said to be at the lower bound. QE was designed for exactly this situation: a way to keep loosening policy after the conventional lever is exhausted.

It has been deployed in response to major shocks, including the global financial crisis and later economic emergencies, when the priority was to prevent a collapse in demand and stave off damaging deflation. In the UK, the decision rests with the Bank of England's Monetary Policy Committee, which uses QE alongside interest rates to pursue the inflation target set by the government.

How it actually works

The mechanics run through several connected channels.

1. The central bank buys bonds. It purchases assets, chiefly government bonds, from investors in the market, paying with newly created money.
2. Bond prices rise and yields fall. When there is a large new buyer, bond prices go up. Because a bond's yield moves inversely to its price, yields fall. Those yields are a benchmark for longer-term interest rates across the economy.
3. Borrowing gets cheaper. Lower long-term rates feed through to the cost of mortgages, corporate loans and other borrowing, encouraging households and firms to spend and invest.
4. Investors rebalance. Sellers who swapped bonds for cash look for other places to put their money, supporting the prices of shares and other assets, and potentially making it easier for companies to raise funds.

The goal throughout is to loosen financial conditions, boosting demand in the economy when interest rates alone cannot do the job.

A useful contrast is with a credit crunch, when lending dries up and money becomes hard to obtain. QE works in the opposite direction, deliberately easing conditions and adding money to the system to keep credit flowing.

Quantitative tightening: the reverse

What is eased can later be tightened. Quantitative tightening, or QT, is the unwinding of QE. Instead of buying assets, the central bank reduces the stock it holds, either by allowing bonds to mature without replacing them or by actively selling them back into the market. Either way, money is withdrawn from the financial system, the opposite of QE's injection.

QT tends to be used when the economy has recovered and inflation needs restraining, and it is generally carried out gradually to avoid jolting markets. The transition from years of easing to active tightening is one of the trickier judgements a central bank faces.

The debate over QE

Few modern policy tools have been argued over as fiercely. The main criticisms cluster around a handful of themes.

• Inflation. Critics warn that creating large amounts of money risks pushing up prices. Supporters counter that QE was often used precisely when inflation was too low, and that its effect on prices depends heavily on the state of the economy.
• Asset prices and inequality. By lifting the value of shares, bonds and property, QE may benefit those who already own assets more than those who do not, a concern central banks themselves have acknowledged.
• Distorting markets. A very large official buyer can blunt the signals that bond markets normally send, and some worry about the long-run effects of holding so many assets on a central bank's balance sheet.
• The exit. Unwinding QE cleanly, without unsettling markets or the public finances, is genuinely hard, and QT is still a relatively young practice.

Defenders argue that QE was an essential response to emergencies, helping to avert deeper recessions and the kind of self-reinforcing decline that can follow a financial shock. The honest assessment is that QE is a powerful but imprecise instrument, easier to start than to stop, whose effects depend on the circumstances in which it is used. Its ultimate test is whether it supports activity and employment, which show up in measures such as GDP, without storing up problems for later.

The bottom line

Quantitative easing is a tool central banks use to support the economy when interest rates are already near zero, by creating new money and buying financial assets, mainly government bonds. It works by raising bond prices, lowering longer-term interest rates, and encouraging spending and investment. Its reverse, quantitative tightening, withdraws that support when conditions allow. QE has been credited with cushioning serious crises and criticised for its effects on inflation, asset prices and inequality. Like any powerful instrument, it is judged less by the theory than by the results, and by how carefully it is wound back down.

Key takeaways

• Quantitative easing, or QE, is when a central bank creates new money electronically and uses it to buy financial assets, mainly government bonds.
• It is used when interest rates are already very low and the central bank wants to give the economy further support.
• By raising bond prices and lowering their yields, QE pushes down longer-term interest rates and encourages spending and investment.
• Quantitative tightening is the reverse: the central bank reduces its holdings, withdrawing money from the system.
• QE is debated for its effects on inflation, asset prices and inequality, and for how cleanly it can be unwound.

Sources

• Bank of England
• International Monetary Fund
• OECD

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