Quantitative Easing

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to to increase the money supply and encourage lending and investment. When short-term interest rates are at or approaching zero, normal open market operations, which target interest rates, are no longer effective, so instead a central bank can target specified amounts of assets to purchase. Quantitative easing increases the money supply by purchasing assets with newly created bank reserves in order to provide banks with more liquidity.

To execute quantitative easing, central banks increase the supply of money by buying government bonds and other securities. Increasing the supply of money is similar to increasing supply of any other asset – it lowers the cost of money. A lower cost of money means interest rates are lower and banks can lend with easier terms. This strategy is used when interest rates approach zero, at which point central banks have fewer tools to influence economic growth. If quantitative easing itself loses effectiveness, fiscal policy (government spending) may be used to further expand the money supply. In effect, quantitative easing can even blur the line between monetary and fiscal policy, if the assets purchased consist of long term government bonds that are being issued to finance counter-cyclical deficit spending.

If central banks increase the money supply, it can cause inflation. In a worst-case scenario, the central bank may cause inflation through QE without economic growth, causing a period of so-called "stagflation." Although most central banks are created by their countries' government and are involved in some regulatory oversight, central banks can't force the banks to increase lending or force borrowers to seek loans and invest. If the increased money supply does not work its way through the banks and into the economy, QE may not be effective except as a tool to facilitate deficit spending (i.e. fiscal policy).

Another potentially negative consequence is that quantitative easing can devalue the domestic currency. For manufacturers, this may help stimulate growth because exported goods would be cheaper in the global market. However, a falling currency value makes imports more expensive, which can increase the cost of production and consumer price levels.

During the QE programs conducted by the U.S. Federal Reserve starting in 2008, the Fed increased the money supply by $4 trillion. This means that the asset side of the Fed's balance sheet grew significantly as it purchased bonds, mortgages, and other assets. The Fed's liabilities, primarily reserves at U.S. banks, grew by the same amount. The goal was that the banks would lend and invest those reserves to stimulate growth.

However, as you can see in the following chart, banks held onto much of that money as excess reserves. At its peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome for the Fed's QE program.

Most economists believe that the Fed's QE program helped rescue the U.S. (and world) economy following the 2008 financial crisis. However, the magnitude of its role in the subsequent recovery is more debated and impossible to quantify. Other central banks have attempted to deploy QE to fight recession and deflation with similarly cloudy results.

Following the Asian Financial Crisis of 1997, Japan fell into an economic recession. Beginning in 2000, the Bank of Japan (BoJ) began an aggressive QE program to curb deflation and to stimulate the economy. The Bank of Japan moved from buying Japanese government bonds to buying private debt and stocks. The QE campaign failed to meet its goals. Ironically, the BoJ governors had concluded that "QE was not effective" just months before launching their program in 2000. Between 1995 and 2007, Japanese GDP fell from $5.45 trillion to $4.52 trillion in nominal terms, despite the BoJ's efforts.

The Swiss National Bank (SNB) also employed a QE strategy following the 2008 financial crisis. Eventually, the SNB owned assets nearly equal to annual economic output for the entire country, which made the SNB's version of QE the largest in the world as a ratio to GDP. Although economic growth has been positive during the subsequent recovery, how much the SNB's QE program contributed to that recovery is uncertain. For example, although it was the largest QE program in the world as a ratio to GDP and interest rates were pushed below 0%, the SNB was still unable to achieve its inflation targets.

In August 2016, the Bank of England (BoE) announced that it would launch an additional QE program to help alleviate concerns over "Brexit." The plan was for the BoE to buy 60 billion pounds of government bonds and 10 billion pounds in corporate debt. If successful, the plan should have kept interest rates from rising in the U.K. and stimulated business investment and employment.

From August 2016 through June 2018, the Office for National Statistics in the U.K. reported that gross fixed capital formation (a measure of business investment) was growing at an average quarterly rate of 0.4 percent, which was lower than the average from 2009 through 2018. The challenge for economists is to detect whether growth would have been worse without quantitative easing.