What Is Quantitative Easing?

Quantitative easing (or QE) is the act of increasing the amount of money in a country’s economy by that country’s central bank. In order for a central bank to increase the money supply, new money must be created and introduced into the economy. A monetary policy of quantitative easing outlines the process by which the central bank will increase the money supply.

According to American investment icon and Starbucks CEO Howard Schultz, “managing and navigating through a financial crisis is no fun at all.”1)Retrieved 27 February 2016 http://www.brainyquote.com/quotes/keywords/financial_crisis.html An economic crisis can develop over a long period of time or arise suddenly, with the impact on the value of a nation’s currency often being catastrophic. If nothing else, Schultz’s quote is very instructive: managing anything through a financial crisis is certainly “no fun.”

Inflation, deflation, pricing instability and decreasing household wealth are just a few negative economic results that can be attributed to an ill-timed crisis. In an attempt to manage these challenges, nations rely upon a designated central bank to craft national monetary policy. If a crisis is severe enough, then unconventional and controversial policies can be adopted to promote economic recovery. The practice of quantitative easing certainly qualifies as being both unconventional and controversial.

Central Banks, Monetary Policy And The Money Supply

A key component of any country’s monetary system is its central banking authority, or central bank. The central bank’s function is managing the country’s currency through the promotion of low inflation rates, and the assurance of pricing stability concerning goods and services.2)Retrieved 29 February http://www.thestreet.com/story/10375486/1/how-do-central-banks-work.html

“Monetary policy” is a comprehensive strategy designed by a country’s central bank to manage the money supply of that country. Monetary policy can be either expansionary or contractionary, depending on which concerns appear to be the greatest threat to economic stability.3)Retrieved 26 February 2016 http://www.centralbanksguide.com/monetary+policy/

If unemployment and low capital investment are the primary challenges facing an economy, then an expansionary policy is likely to be adopted to spur economic growth. If inflationary concerns are of paramount importance, then a contractionary monetary policy would likely be adopted. In either situation, the central bank will look to implement monetary policy with the goal of increasing or decreasing the domestic money supply in an attempt to promote positive economic activity.

There are several traditional methods of managing a nation’s money supply. The central bank may buy or sell government bonds on the open market, purchase debt from the private sector, or actively manipulate interbank interest rates. In the event traditional methods are deemed ineffective, then more unconventional methods of influencing the money supply are considered. The practice of “quantitative easing” has become the most relied upon, and controversial, form of unconventional monetary policy.

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Quantitative Easing: Process

The first step taken by a central bank under QE is to create new money, a process often referred to as “printing money.” This is a bit misleading, because in reality, no physical money is created. The created money is in the form of balance sheet credits referred to as “central bank reserves.”4)Retrieved 28 February 2016 http://positivemoney.org/how-money-works/advanced/how-quantitative-easing-works/ The newly created central bank reserves remain at the disposal of the central bank until a course of action is chosen by which to introduce the reserves into circulation.

After the new capital is created, it must be introduced into the money supply. Large-scale asset purchases from both the public and private sectors are one way in which this is accomplished. The acquisition of government-issued bonds, corporate bonds, and commercial paper on behalf of the central bank act as the conduit by which the introduction of the new capital takes place.5)Retrieved 28 February 2016 http://www.cnbc.com/id/43268061

The central bank can also increase the money supply through directly issuing loans to commercial banks. Essentially, the newly created central bank reserves are transferred to the commercial banks for lending to the private sector. Again, the goal is to spur economic growth through increasing the availability of credit and capital to participants within the private sector.

Although the mechanics of QE are unconventional and often times complex, the stated goals remain relatively basic. First, encourage economic growth through ensuring the availability of capital to the credit market. Second, promote lending through the assurance of low interbank interest rates.

Quantitative Easing In Practice: Japan

On March 19, 2001, the Bank of Japan implemented the first quantitative easing strategy in modern history. The decision represented an unprecedented shift in monetary policy by the Bank of Japan (BOJ). Faced with rising inflation and stagnant economic growth, the BOJ chose to inject vast stores of capital into the commercial banking system along with instituting a program of large-scale government bond purchases. The goal was to generate activity within the credit market and stabilize inflation rates. The policy remained in place until 2006, at which time the measures of inflation and economic growth were deemed acceptable.6)Retrieved 29 February 2016 http://www.frbsf.org/economic-research/publications/economic-letter/2006/october/did-quantitative-easing-by-the-bank-of-japan-work/

So, the question becomes, did the Japanese monetary policy of quantitative easing succeed? That question is a point of contention, leaving economists and financial experts divided. On one hand, the actions of the BOJ did support weaker Japanese banks by providing them with adequate capital needed to weather a difficult financial period. On the other hand, the Japanese economy did not experience robust economic growth and a return to the heyday of the Nikkei.7)Retrieved 29 February 2016 http://seekingalpha.com/article/908841-the-effectiveness-of-quantitative-easing

Quantitative Easing In Practice: United States

The financial crisis of 2008 marked the introduction of QE into the United States’ monetary policy. The United States Federal Reserve (i.e. Fed) took action in response to a massive freeze in the credit market. It pledged to “bail out” government-backed mortgage providers in addition to large investment banks that were hard hit by the downturn in the US housing market.

The Federal Reserve’s initial foray into quantitative easing became known as QE1. In November 2008, the Fed pledged US$100 billion to Government Sponsored Enterprises (GSE), and US$500 billion to Mortgage-Backed Securities (MBS). The capital was increased in March 2009, as another US$200 billion went to GSE and MBS received capital totaling US$1.25 trillion.8)Retrieved 29 February 2016 http://www.nasdaq.com/investing/glossary/q/qe1 In addition to the mortgage bailout included in QE1, the Fed cut interbank interest rates to near zero and pledged to purchase US$300 billion of long-term Treasury securities from the US government.

Although the initial timeline for QE1 was open-ended, the following year marked its official conclusion. Quantitative easing remained a crucial part of US monetary policy with the launch of QE2, QE3 and QE “tapered.” Essentially, the era of quantitative easing in the United States ran from 2009 to 2014.9)Retrieved 1 March 2016 http://www.bankrate.com/finance/federal-reserve/financial-crisis-timeline.aspx

From a purely empirical standpoint, the era of QE in the United States has brought lower mortgage rates, stable inflation and an improved employment situation.10)Retrieved 1 March 2016 http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/10526947/Farewell-QE-you-have-been-a-magnificent-success.html Advocates of the QE programs in the United States claim that the capital created by the Fed loosened up credit markets, stymied unemployment and provided a boost to equities valuations. Opponents of QE claim that the bond-buying practices and capital creation enacted by the Fed will ultimately lead to extreme dollar devaluation and a financial burden being placed upon future generations.

Quantitative Easing: A Point Of Contention

Whether one is a CEO directing a multinational corporation through turbulent economic times or the acting chairman of the United States Federal Reserve, one fact remains the same: The chosen course of action in response to a financial crisis will be hotly debated, and the “correct answer” may or may not exist. A central bank’s practice of quantitative easing is one of the most divisive financial topics.

Critics of QE cite several concerns facing the domestic currency. Devaluation, hyperinflation and the monetizing of a country’s national debt are a few such concerns. Hyperinflationary examples ranging from World War II-era Axis powers of Germany and Hungary, to Argentina and Peru in the 1980s are often used to illustrate the dangers related to the rapid growth of a domestic money supply.11)Retrieved 1 March 2016 http://www.econlib.org/library/Enc/Hyperinflation.html At its core, the argument against QE is simple: once the printing presses turn on, they are nearly impossible to turn off.

Advocates of QE see the policy as a useful tool in regards to jumpstarting a stagnant economy. When interest rates cannot be cut anymore and unemployment is high, the introduction of capital into the economy can stimulate growth. Supporters of QE also see the devaluation of currency as a good thing. Arguments for value being created within the export sector, and the promotion of a positive trade balance, are valid when the domestic currency becomes devalued.12)Retrieved March 1 2016 http://www.barrons.com/articles/SB50001424052970204742304575546140224527342

The debate over the effectiveness of QE policies rage on between financial experts, without a definitive right or wrong answer. The fact remains that the use of QE strategies by developed countries has become common since 2001. In many ways, the long-term ramifications of such policies are yet to be known. Ultimately, time will tell.

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