What Is Quantitative Easing And How Does It Work?

Quantitative Easing is when the central bank “creates” new money to fund-large scale asset purchases in order to boost consumer spending.

Amidst rising uncertainty as a result of the spread of the coronavirus, central banks around the world have resorted to innovative monetary policy tools in an attempt to stabilize the global economy. One such tool, which the US Federal Reserve implemented this past weekend, is Quantitative Easing.

The Fed announced a $700 billion quantitative easing program in order to restore “smooth market functioning” during this growing global crisis. When interest rates are already low and public spending continues to flatline, quantitative easing acts as a sort of defibrillator for the economy that is supposed to jolt it back to life.

So what is quantitative easing, exactly?

Inflated Dollar(mipan)s

QE is an emergency tool to pump up an economy that’s stagnating (Photo Credit : mipan/Shutterstock)

Quantitative easing is an innovative monetary policy by which a country’s central bank “creates” new money and uses it to fund large-scale purchases of government and corporate bonds in order to boost consumer and private sector spending. Before we can understand the intricacies of this process, let’s contextualize this with a bit of background in finance. Those who are aware of the basics, you can skip ahead.

What are Bonds?

Imagine that your friend John asks to borrow $100 from you and promises to pay you back with 10% interest in a year. You happily oblige, but ask John to put it down in writing, lest either of you forget. John gives you a note stating that he will pay you $110 at the end of the year. Now, consider that you need that money back soon and can’t wait for a whole year. You could speak to Toby, who is also friends with John, and get him to buy John’s note from you. Of course, he’s not going to pay you the full $110. He’ll negotiate down to $105. You say fine and take the cash for whatever it is you need the cash for. Now, Toby holds the note from John. Toby may decide to sell it to Mark for $106, who may pass it along to somebody else. At the end of the year, whoever has the note from John gets $110 from John. When you bought the bond, essentially, that note is a bond worth $110 that you initially purchased from John for a price of $100.

A man and a women hands hold a money bags in the public park for loans(Watchara Ritjan)S

Since you trust John, you lend him money by purchasing his “promise to pay you back with interest” (bond) (Photo Credit : Watchara Ritjan/Shutterstock)

However, I must point out that each of them is not getting the same level of benefit from the bond. When you bought the bond for $100, you were set to make $110. The ‘yield’ on John’s bond was 10%. When you sold it to Toby, he bought it for $105. That brings the yield down to 9.5%. Moe bought it from Toby at $106, making his yield 9.4%, since he will still end up making the same $110 on a payment of $106. The level of trust that these people have in John plays a major role in the growth of John’s bond price. If Toby or Mark did not trust John as much as you did, they may agree to buy his bond from you at a cheaper rate, say $95. In times of high confidence and trust, bond prices are high and yields are low. In times of recession and distrust, prices fall and yields go up.

Governments and corporations issue such ‘bonds’ all the time with varying periods of repayment, ranging from a few weeks to several decades. People are happy to buy these bonds, as they trust the issuing authority to honor its obligation. In fact, when people have a high level of trust in a company or the government, these entities can issue bonds at very low-interest rates. The people are guaranteed a good return at the end of the period and the companies have a cheap means of funding large infrastructure projects, research and development, or huge expansion plans. However, people’s trust isn’t something one can take for granted. In times of recession, the availability of funds in the economy may be scarce.

What happens in a Recession?

During times of recession, the economy is overflowing with uncertainty. People are afraid to spend their money and investing is the last thing on their mind. They choose instead to hoard cash in their savings accounts, which earn minimal interest. In such a situation, companies may lack the funds required to build new products, expand their presence or sometimes even sustain day-to-day operations. Consequently, they decide to save what little they have. To further prompt savings, they start to cut wages, lay off employees and shut down underperforming business units. This leads to a further decrease in the savings of people and more of a decline in their enthusiasm for investment. Therefore, they decide against investing in the economy and the vicious circle continues.

Economy and health care as an economic pandemic fear and coronavirus fears or virus Outbreak(Lightspring)s

We are currently in a recession, courtesy of COVID-19 (Photo Credit : Lightspring/Shutterstock)

To battle a stagnating economy and break this vicious circle, the central bank intervenes with remedies in the form of monetary policy changes. One notable remedy is the lowering of the central bank interest rate—the rate that the bank charges other banks for keeping funds overnight. The central bank’s interest rate acts as a benchmark for all other rates in the nation. When this rate is low, the interest rates on your mortgage or credit card tend to be low as well. As a result, more consumers are inclined to take out mortgages to buy cars and houses and spend more at malls and stores using their credit cards. Since credit is cheap, consumers cash in on it to score a bargain. Or at least, that’s the hope.

During the financial crisis of ’08, the Fed brought down the interest rates to record lows, yet consumer and corporate spending continued to remain muted. People were simply too scared to spend what little they had left for fear of the crisis getting worse. The economy needed a bigger jolt. That’s when Ben Bernanke, Chairman of the Federal Reserve at the time, came up with the concept of Quantitative Easing.

How does Quantitative Easing Work?

The central bank of a recession-hit economy digitally “creates” a boatload of money (much more sustainable than physically printing the same amount). This money is pumped into the economy via the financial markets. The central bank becomes an investor and starts placing huge orders for government bonds and corporate bonds. In cases when a sector of the economy is particularly under fire, the bank may choose to allocate a large proportion of funds to buying bonds of those firms. Think about the airline sector after 9/11.

finance, economy and monetary policy concept(Syda Productions)S

The bank floods the economy with fresh cash to promote private sector spending and consumer confidence (Photo Credit : Syda Productions/Shutterstock)

When there are trillions of dollars’ worth of bond purchases happening in the economy, the public takes note and the markets react. Bond prices start to go up and people get excited about investing again. As markets go up, so does spending. People buy bonds, stocks and luxuries, while companies once again begin to develop and expand. With the growth in bond prices, the bond yields go down. Companies can then come up with fresh bond issues at lower yields. Thus, they get to have more money at lower rates. Eventually, the markets stabilize and the central bank takes back that initial jolt of money it created, tucking it away until it’s needed once again.

Facade on the Federal Reserve Building in Washington DC(Paul Brady Photography)S

The Fed spent about 20% of the US GDP in asset purchases during the quantitative easing program (Photo Credit : Paul Brady Photography/Shutterstock)

During the crisis of ’08, the banks managed to “create” and spend money amounting to about 20% of the country’s GDP. In the US, the Federal Reserve implemented about $3 trillion of quantitative easing over 16 months to fund the purchase of treasury bonds and mortgage-backed securities (those little instruments that wreaked havoc in the US housing market). In Japan, the central bank even went so far as to purchase equities in the market.

Issues with Quantitative Easing

Specifically, during the ’08 financial crisis, the Fed was allowed to purchase “government-guaranteed” debt (mortgage-backed securities), which predominantly included the debt of home buyers with excellent credit scores. These purchases may have helped several people refinance their loans with a lower interest rate, but the Fed could not touch the debt taken on by people with less than stellar credit scores. Consequently, those hit hardest by the crisis—home buyers with low credit scores—were not particularly helped by Quantitative Easing.

Quantitative Easing has potentially set a dangerous precedent in the minds of investors. No matter how bad the situation gets, the central bank is now able to implement quantitative easing and almost guarantee a good return on even some of the most risky assets. According to an analysis by Ramin Toloui from the Stanford Institute of Economic Policy Research, investors poured money into risky assets when the Fed announced their quantitative easing program. In fact, the market made one of the biggest surges of the decade during the program. Making risky (read: irresponsible) investments in the hope of a central bank “bailout” isn’t the most prudent strategy, but it seems to be one that has actively been pursued since quantitative easing was introduced.

Conclusion

Quantitative easing is an innovative monetary policy tool that has proven to be notably helpful in the management of a stagnating economy. However, it is still a tool in its nascency. The crisis caused by COVID-19 warrants the central banks deploying this tool once again. Perhaps the banks have had time to iron out the kinks that existed in its previous implementations. How well those changes will work out for all of us, only time will tell!

References:

  1. University Of Pennsylvania
  2. Stanford University
  3. Harvard Business School
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Abhishek Kulkarni is an investment banker turned writer and standup comedian. After a graduate degree in business administration and a stint at Citigroup, Abhishek decided to give it all up to follow his passion for the creative arts. Presently he sits in an armchair indulging in whimsical thought, writing on topics that tempt his curiosity and moonlighting as a comic in the city of Bombay

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