Quantitative easing (QE) is the term used to define large-scale purchases of government securities by central banks from the open market in an effort to boost the economic cycle and lower the yields on bonds and other debt instruments.
The central banks funds this large-scale purchase of government securities by bringing more money into existence.
Central banks resort to Quantitative easing (QE) in situations when the economy is in a downward trend and there is contraction in consumer demand leading to deflationary pressures on the economy.
The role of Central Banks in boosting the Economic Cycle:
The central banks have an important tool in their arsenal to fight against an economic downturn – the bank rate.
The bank rate is the rate at which banks can borrow money from the central banks. If the bank rate is low, the banks can in turn lend to consumers and businesses at a lower rate.
Lower rate of interest on borrowings encourages consumers to borrow more money to spend (for example in a new house or a car) or businesses to borrow more to invest (for example in research or development or setting up a new plant).
All this spending helps put more money in the hands of people, which revives demand and helps in the revival of the economy.
There is however, a limit to how low the bank rates can go. For example, in many of the developed nations this rate is already closer to ‘zero’. Reducing bank rates further in such situations might not be enough to give the economy any real boost.
This is where quantitative easing comes in.
Quantitative Easing & Bond yields:
In situations where lower bank rates are not enough to expand lending operations of the commercial banks, central banks can attempt to inject more money into the economy by purchasing government securities in large quantities directly from the public including banks and financial institutions.
This large-scale purchase of government bonds by central banks – creates a surge in demand for such bonds in the financial markets and leads to an increase in the price of such bonds.
We know that bond price and their ‘yield’ have an inverse relationship. So, when bond prices move up, their yields fall. An increase in the price of government securities leads to a reduction in the ‘yields’ on those bonds.
You can read more on bond yields here.
Here, the hope is that with falling Government bond yields, investors would switch to investing in corporate debt in the primary markets – which would help bring down yields on these instruments as well and thus help businesses raise funds at cheaper rates of interest.
Apart from a reduction in interest rates, quantitative easing aims to open up bank reserves, allowing banks to lend more.
Quantitative Easing & Bank Reserves:
We know that banks and other financial institutions in the lending business are required to keep a fraction of the funds available as reserves with the central banks.
Money, over and above the reserve requirements can be lent out by these institutions.
When, the central banks acquire government bonds from these banks and financial institutions, the proceeds typically be lent out in their entirety. No further reserve requirement apply to these proceeds.
This effectively reduces the reserve requirement and frees up more funds for the banks to lend – leading to an increase in money supply and a fall in interest rates.
This provides an incentive for individuals and businesses to borrow more – thereby stimulating the economy.
Quantitative Easing & Asset Prices:
We have already discussed that quantitative easing might help bring the interest rates on corporate debt down.
Quantitative easing can also have an impact on price of other asset classes like stocks or real estate.
We already know the QE can lead to a fall in bond yields.
When the central bank buys bonds from investors in the open market, the investors in search of higher yields, could choose to invest the proceeds in stocks or real estate assets – driving the price of such asset classes higher.
Here again the hope is that the increase in the wealth of investors, following such rise in asset price, would give them the confidence to spend more – which could then help prop up demand in the economy and set an economic recovery in motion.
Article references:
- Bank of England: https://www.bankofengland.co.uk/monetary-policy/quantitative-easing