What is Quantitative Easing and how does it work?
We’ve all heard the term ‘quantitative easing.’ With the global economy seemingly in a state of crisis for the last five years it’s been hard not to. But what is quantitative easing? How does it work? Why do the central banks use it – and what does it mean for you?
Clearly, many of the economies around the world need help. The normal reaction of a central bank – whether it’s the Bank of England, the US Federal Reserve or the European Central Bank – will be to lower interest rates when it wants to boost an economy. The problem is that interest rates are already at rock bottom: they’re so low that lowering them further will have no significant impact. So the central banks need a new tool – and that’s where ‘quantitative easing’ comes in.
Simply put, quantitative easing is the act of creating more money. Central banks can do this because everyone accepts their money. These days, creating more money is as easy as a keystroke on a computer – it’s not a question of printing more banknotes! The aim of doing this is to bring down interests rates paid by companies and households, by promoting increased liquidity in the economy and increased lending by the commercial banks.
With its new money, the central bank can buy whatever it wants – government bonds and corporate bonds are typical purchases. With increased demand for these bonds, the price should rise and the yield on them should fall. As much of this new money will end up with the ‘high street’ banks, they should find that their liquidity position is improved and hence they’ll be more willing to lend to businesses and consumers.
So much for the theory. Does quantitative easing work in practice? Clearly there are risks. Firstly, any ‘creation’ of extra money brings with it an inherent risk of inflation – but as we’re seeing, in the current economic climate the central banks think that risk is a price worth paying. Secondly, a central bank could lose money on the bonds that it buys. If that happens even more money may need to be created in the future, further fuelling inflation. Alternatively the losses may need to be recouped through higher taxation. You could also argue that lowering interest rates can harm an economy – after all, many savers rely on a good rate of interest to boost their income. If these people receive less income because of lower interest rates, then inevitably they’ll spend less.
Finally – as we’ve seen in countries like Greece and Spain – the very act of using quantitative easing may simply destroy confidence in an economy, making the whole measure counter-productive.
The problem is that no-one really knows how much quantitative easing is enough, and how much is too much. Even the central banks are having to play it by ear, which is why you’ll see headlines such as ‘Bank of England pumps £50bn into economy in another round of QE.’
Opinions are split on whether quantitative easing has worked. The International Monetary Fund says it has. Commentators such as Alan Greenspan, the former head of the US Federal Reserve, are less sure, arguing that there has been “very little effect.” There’s also an argument – particularly in the USA – that using quantitative easing to buy mortgage backed securities that are potentially worthless amounts to little more than transferring a financial liability from the banks to the taxpayers.
One thing is for sure: with the world’s economies continuing to struggle, you’ll hear plenty more of ‘quantitative easing.’ Don’t think it’s just a technical term used by bankers – it has long term implications for all of us.
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Dedicated personal advice with the highest professional abilityMr O - Shipston on Stour