Friday, May 24, 2024

Quantitative Easing (QE)

Quantitative Easing (QE) is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy fails.

It’s more colloquially known as “printing money,” except the actual paper money is never printed. Money is simply “created” or “tapped” electronically.

“Tap money” or “Typ money” is more accurate than “Print money”.

Quantitative easing aims to increase the price of government bonds while driving down their yields. It’s a method used to push banks to invest in riskier assets and lend more to businesses and individuals.

Quantitative easing is just a fancy word that describes central bank purchases of “assets” from commercial banks and other private institutions.

These “assets” are typically limited to government bonds, but depending on the central bank, other assets may be accepted, such as mortgage-backed securities (MBS) and corporate bonds.

For example, a U.S. pension fund would sell Treasury bonds to the Federal Reserve, and in exchange, the pension fund would receive a deposit (funds) in an account at one of the major banks, such as Bank of America.

U.S. banks will end up with new deposits (pension fund liabilities) and new assets (the Fed’s central bank reserves).

The amount increased by QE at the same time:

  • Reserves (“central bank currency” used by banks to pay each other)
  • Deposits (“Business Bank Funds” in personal and business bank accounts)

Only “commercial bank money” or deposits can truly be used in the real economy.

Reserves or “central bank currency” are for “internal purposes” only, meaning that the currency can only be used between commercial banks and the central bank .

treats Deposits (commercial bank money) as “external money” and Reserves (central bank money) as “internal money”.

Deposits can be used as currency in the outside world…the real world. Reserves can only be used within the banking community…the network of commercial banks and central banks.

The central bank implements quantitative easing by purchasing financial assets and corporate bonds from commercial banks and other private institutions.

The act of

purchasing these assets creates new reserves (“central bank money”) that are said to be lent out into the real (non-financial) economy, allowing individuals and companies to acquire money they do not otherwise have. There will be no capital gained.

In short, QE has two simple purposes:

  1. Quantitative easing aims to lower long-term interest rates to encourage borrowing and economic growth, and to stimulate more risk-taking by pushing investors to invest in stocks and non-government bonds.
  2. QE also aims to exert a powerful signaling effect and strengthen the Federal Reserve’s guidance on future interest rates. By buying longer-term assets, the Fed “persuades” investors that it will keep interest rates lower for longer than it otherwise would.

The problem is that all this new money is not entering the real (non-financial) economy.

It’s back to the financial economy!

The money created through QE is used to purchase government bonds from the financial markets!

Yes, the newly created money ends up going right back into the financial markets, causing the bond and stock markets to reach all-time highs.

Another effect of quantitative easing is to try to “control” long-term interest rates.

Under normal circumstances, the central bank can only indirectly “affect” long-term interest rates by controlling short-term interest rates.

More details later. But know that, typically, central banks cannot control long-term interest rates, but with quantitative easing, they can, or at least try to, directly .

The central bank does this by buying long-term debt like the 30-year Treasury note. If you buy all these bonds, you actually increase demand.

So if demand grows more than supply, prices will rise.

For bonds, when their prices rise, their yields fall.

This is how central banks try to control long-term interest rates.

They buy long-term bonds, reducing supply in the market, causing prices to rise, which in turn causes yields to fall.

To sum up, the goal of quantitative easing (QE) is to increase banks’ excess reserves and increase the prices of purchased financial assets, thereby reducing their yields.

How does QE work?

Governments and central banks try to maintain economic “stability”.

They want the economy to grow, but not too much, otherwise it will lead to runaway inflation, but not too little, lest it stagnate, or even worse, lead to recession (negative growth).

Their goal is to get the economic growth rate “just right.”

One of their main tools for controlling growth is raising or lowering interest rates. ​​

Lower interest rates encourage people or companies to spend money rather than save.

But when interest rates are near zero, central banks need to adopt a different strategy — such as injecting money directly into the financial system.

This process is called quantitative easing or QE.

A central bank uses the money it “prints” (or more accurately, electronically creates) to buy assets, usually government bonds.

The money is then used to purchase bonds from investors such as banks or pension funds. This increases the total amount of funds available in the financial system.

Making more money available should encourage financial institutions to lend more to businesses and individuals.

It can also drive down interest rates across the economy, even as the central bank itself has cut rates to rock-bottom levels.

This in turn should allow businesses to invest and consumers to increase spending, thus having a knock-on effect on the economy.

Quantitative Easing (QE)

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