What Is Quantitative Easing (QE)?

What Is Quantitative Easing?

I’ll explain QE based on how it works in the European Union. The FED has a very similar approach. Let’s get into it! QE is when the ECB buys bonds from banks. These purchases drive up the price of bonds and increase the money available to banks.

As a result of the increased bond prices and available money, interest rates fall, and loans become cheaper. This results in increased spending, as saving is discouraged and borrowing money becomes cheaper. The economy gets a significant boost, as both consumption and investment grow. This generally creates new jobs too.

So far, sounds pretty neat right? It really depends on who you ask. QE is not without problems and shortcomings. For example, interest rates can only go down so much. As we have seen in the EU, negative interest rates are being introduced to the higher net worth accounts, but it’s still a rare phenomenon. Another problem lies in the fact that by buying up debt at such a scale, you can keep failing businesses alive for longer than economists argue is healthy. Keeping these businesses afloat will result in problems when the capital injection stops, and all the businesses fail at once, they argue.

On top of it all, QE is a relatively new and experimental thing. With little real-world data to determine the long-term effects, economists are highly divided on whether or not QE is the right tool for the job as QE is generally followed by higher inflation.

Quantitative Easing vs Open Market Operations

As discussed in the introduction of this article, many people confuse open market operations and QE. While the two are very much alike, Quantitative Easing happens on a much larger scale.

Open market operations happen on a regular basis; where central banks buy small portions of short-term government debt to keep interest rates down. Pretty similar to QE, but the difference lies in the size of the operation. Quantitative Easing is considered to be a large-scale emergency response, where central banks inject huge amounts (trillions of dollars, this time around!) of capital into the economy.

Quantitative Easing and Inflation

This large-scale operation usually happens with reserves (money they already have) of the Central Bank. The frequent association of QE with “money printing” is therefore inaccurate, or at least used to be. As I said before, the definition of QE has been modified by the ECB to the point where it talks about money creation rather than “moving funds around”.

I think we can all agree “money creation” sounds an lot like money printing, with a nicer word. Economists are already worried about the tendency for QE to cause inflation, but now that additional money is created to support these asset purchases, things can get out of hand quickly, as we are seeing now.

As a result, the consensus seems to be that these higher-than-normal inflation rates have been primarily caused by QE. Some experts on the matter argue that inflation is also due to the global supply chain troubles caused by port-cities locking down. I – a non-expert, for that matter – believe it comes down to a combination of multiple factors, including the two I just mentioned.

Quantitative Easing and Markets

Inflation and QE are not the only two things linked closely. Let’s look at the performance of the Nasdaq and the timing of QE. The ECB announced their first 750 billion euro QE package on the 18th of March. The Federal Reserve beat them to it, announcing their first “large-scale, comprehensive package of 700 billion USD worth of QE” on the 15th of that month. Central banks saved the stock market.

A few days later, global markets found a bottom and rallied at speeds we never saw before, continuing to rally at a slowly diminishing rate for over a year. Just six months ago, the central banks announced it was time to slow down the printing presses and start the so-called process of tapering. Contrary to popular belief, this does not actually mean the printing presses come to a grinding halt. Instead, the pace at which money is printed is simply reduced.

The chart below shows how closely QE and the growth of the Nasdaq have been correlated. This worries some, because if that growth phase was driven by QE, what happens when the music stops?

I guess time will tell. It does not help that QE is ending in a period with global political uncertainty going on where supply chains are damaged beyond repair. At the same time, central banks are also adjusting the interest rates upwards, another form of monetary policy available to them.

These are incredibly complex time; but creating a basic understanding of the driving forces behind economies is incredibly insightful & useful if you want to plan ahead. I will continue to study monetary policy and markets, and look forward to sharing my findings again soon.

Finally, the usual disclaimer: I do not pretend to be an extreme subject matter expert. I just find these things interesting and am on my learning journey just as much as you are. This article is based on my limited knowledge and experience, and it does not constitute advice.