Most central banks exist solely to keep inflation under control by increasing or decreasing the money supply. Using monetary policy, these banks typically increase the money supply by purchasing or selling government debt with electronic money. Other unconventional techniques like quantitative easing are used when these traditional methods fail.
Quantitative easing involves the purchase of financial assets from private sector entities, which enables banks to effectively inject cash into the financial system. The desired effects include lower yields, greater liquidity and increased lending. And ultimately, these effects tend to increase inflation targets and support economic growth.
How Quantitative Easing Works
The controversy surrounding quantitative easing has led to many misunderstandings. While quantitative easing generally involves central banks purchasing financial assets with newly minted currency, that's like saying driving a car generally involves pressing the gas petal. In reality, there are many different types of quantitative easing designed for different purposes.
For example, some of the U.S. Federal Reserve's actions have been designed to shift bank balance sheets from long-term to short-term assets. The goal of this action was to help increase lending and liquidity, but the process did not result in any new money being printed. In contrast, many other programs have been designed to directly inject liquidity through outright purchases.
Here are some other examples of non-traditional QE programs:
- Term Deposits - Central banks can offer commercial banks interest to deposit money at its facilities and then use that money to purchase financial assets in order to remain cash neutral by simply moving cash from one party to another.
- Reserve Rates - Central banks can increase reserve rates, which would force banks to hold a higher portion of their funds at its deposit facility. Meanwhile, central banks could inject liquidity by purchasing assets in the same amount.
Effects of Quantitative Easing
Quantitative easing causes security prices to rise, lowering yields and making those securities less attractive as an investment. As a result, investors tend to seek better returns by purchasing corporate debt and equities, which lowers those businesses' financial costs, boosts investment and leads to a better economic outlook over the long-term.
At least that's the theory. In practice, the effects of quantitative easing have been mixed at best when employed in various countries around the world. For instance, banks tend to hoard cash during times of crisis, which can negate the intended effects of quantitative easing. Other programs have seen only a temporary boost that quickly disappears.
Japan's use of quantitative easing in the early 2000s was seen as largely unsuccessful, with banks refusing to lend money despite the extra liquidity. However, International Monetary Fund (IMF) suggested that the actions have been successful more recently in increasing market confidence and bottoming out the recession of the G-7 economies during Q2 2009.
QE1, QE2 and QE3 in the U.S.
The United States began a well-publicized period of quantitative easing in 2008 at the beginning of the financial crisis. After risk-free short-term nominal interest rates neared zero, central banks were unable to use traditional monetary policy to affect the markets. The securities covered by these actions ranged from Treasury bonds to mortgage-backed securities.
A second round of quantitative easing was initiated in November of 2010 with the purchase of $600 billion in Treasury securities by the end of the second quarter of 2011. Since then, the U.S. Federal Reserve has indicated that it stands ready to intervene further, if necessary, which has kept the markets prepared for a third round, called QE3.