Quantitative Easing: A Fed’s Tool to Foster Economic Growth

Quantitative easing (QE) is a monetary policy measure employed to encourage economic growth. Over time, the central bank acquires a significant stash of securities in an effort to expand the money supply, loosen lending, and lower interest rates.

Quantitative easing can assist with getting the economy out of recession and prevent inflation from falling below the inflation target of the central bank. However, QE programmes are often criticized for their side-effects and hazards, which include the policy being more effective than anticipated in combating deflation, or insufficiently effective if banks continue to be reluctant to lend and potential borrowers are averse to borrow. In the United States, QE policies are implemented by the Federal Reserve.

In this article, we will examine the definition and implementation of quantitative easing.

Quantitative Easing: Definition

In order to cut interest rates and stimulate the economy, the Federal Reserve has a number of measures at its disposal. Notably, they can reduce the overnight interest rate charged to commercial banks when they borrow money from the Federal Reserve, and they can also reduce reserve requirements to enable banks to lend more money.

Both of these have an immediate effect on short-term interest rates. To actively influence long-term interest rates, the Fed can engage in huge purchases of Treasury bonds and other securities.

When the Fed acquires assets, it increases the amount of money in circulation and raises the price of long-term bonds, resulting in lower long-term interest rates. Individuals and businesses are incentivized to spend when they have access to more money at lower interest rates, hence fostering economic expansion.

Quantitative Easing in Action

Quantitative easing can action several effects on the economy.

Credit channel – By supplying liquidity to the banking sector, quantitative easing makes it simpler and less expensive for banks to offer loans to businesses and people, hence promoting credit expansion. In addition, if the central bank purchases riskier financial instruments than government bonds (such as corporate bonds), it might boost the price and decrease the interest return of these riskier assets.

Portfolio rebalancing – By implementing QE, the central bank transfers a significant portion of the market's safe assets to its own balance sheet, which may cause private investors to seek for other financial products. Due to the scarcity of government bonds, investors must “rebalance” their portfolios with alternative assets. In addition, if the central bank purchases riskier financial instruments than government bonds, it can also reduce the yield on those assets.

Exchange – Through the interest rate mechanism, QE tends to devalue a country's currency rates relative to other currencies, as it increases the money supply and reduces the return on financial assets. Lower interest rates result in a capital drain from a nation, diminishing foreign demand for its currency and resulting in a weaker currency. This immediately helps exporters and export sectors in the country by increasing export demand.

Fiscal stimulus – By reducing rates on sovereign bonds, quantitative easing makes it more affordable for governments to borrow on financial markets, which may enable the government to give fiscal boost to the economy. Quantitative easing may be considered as a debt refinancing operation of the “consolidated government” (the government plus the central bank), in which the consolidated government retires government debt securities and refinances them into central bank reserves via the central bank.

Higher asset values – When a central bank purchases government bonds from a pension fund, the pension fund may invest the proceeds in higher-yielding financial assets, such as stocks. Moreover, when demand for financial assets is great, their value rises. This increases the wealth of firms and families that hold shares, making them more inclined to spend more and so enhancing economic activity.

Furthermore, some economists say that the primary impact of quantitative easing is its effect on market psychology, suggesting that the central bank will take exceptional efforts to promote economic recovery. For example, many economists consider that the Federal Reserve's quantitative easing policy aided in rescuing the U.S. and worldwide economies during the 2007-2008 financial crisis.

Quantitative Easing Risks

Nonetheless, quantitative easing encompasses several risks, namely:

Inflation risk – As an economy's money supply grows, the likelihood of inflation rises. As the liquidity moves through the system, central banks stay attentive, as there is often a 12- to 18-month lag between the rise in the money supply and the inflation rate. A quantitative easing policy that does not stimulate the anticipated economic growth but creates inflation can potentially result in stagflation, a situation in which both the unemployment rate and the inflation rate are high.

Constrained lending – As bank liquidity grows, a central bank such as the Federal Reserve cannot compel banks to boost their lending operations, nor can it compel people and companies to borrow and invest. Due to the uncertain economic climate, this results in a “credit crunch” in which cash is hoarded in banks or firms hoard cash.

Currency depreciation – As the money supply expands, quantitative easing may depreciate the national currency. While a devalued currency might benefit domestic producers by making their exports more competitive on the international market, a declining currency value makes imports more expensive, hence raising production costs and consumer prices.

Quantitative Easing: The Bottom Line

Quantitative easing is a relatively new instrument in the Federal Reserve's armory of monetary policy, having been employed just twice in the past fourteen years. There are potential hazards to the method that may not be completely understood or quantifiable at this time, but the outcomes thus far appear to be beneficial. For instance, the use of quantitative easing during the COVID-19 epidemic may have led to the overinflation of equity markets throughout 2020-2022, hence leading to the present collapse at mid-2022.

Consequently, the Federal Reserve is likely currently improving the technique's implementation and analyzing its findings. In spite of this, there is widespread support for the measure, which is viewed as a viable backup for averting even more severe damage during times of economic difficulty.