Quantitative Easing for dummies

by Isabel Mateo

Lately, we have been hearing a lot about quantitative easing (QE) in the media. However, as this is a rather specialized topic, most people, even some economic press readers, do not have a clear notion of what QE is. That is why my friend Grega invited me to write this post for his blog. He said he needed someone to explain QE for dummies. Thus, I did not have to worry about a title anymore!

Source: (c) economist.com
Source: (c) economist.com

So, let’s get started with some basic notions that probably most of you already know (that way you will not feel so dummies at the beginning, well, if this post goes as well as I hope, you should be QE experts at the end of it).

Ok, so you know that central banks have usually a main task (sometimes more1). In the case of the European Central Bank (ECB), this task is maintaining price stability, concretely keeping inflation close but below 2% over the medium term. In order to achieve this goal, the ECB has a secret (ok, maybe not so secret) weapon: interest rates. Once a month, the ECB fixes interest rates for lending money to banks. This reflects in the way banks lend to households and businesses.

So, this is the way it works: if inflation goes high, the ECB raises interest rates. That way, it will be more expensive for banks to borrow from the ECB and they will be less willing to lend to households and businesses. The latter will consume less and inflation will be kept at a bay. The underside of this mechanism is that, when demand falls, so do jobs, so not a perfect world. This type of policy is usually implemented in times of economic growth.

On the other hand, when inflation is low, the ECB drops the rates so that banks find it attractive to lend money. Liquidity comes to households and businesses, so they spend more money and inflation increases. As demand increases, more jobs are created. This is the usual policy in times of recession and it is actually the policy the ECB has been using for the last few years.

However, there is a problem – interest rates cannot go beyond 0%2. As the ECB has been lowering types for a while, at the moment it has not much room for action. What to do them? The answer is Quantitative Easing.

QE happens when a central bank literally creates new money. Nowadays this happens electronically, although the process is traditionally known as printing money. The ECB uses this new money to buy government bonds in the secondary market3, so to bond holders such as banks or investment funds. Like that, the ECB injects liquidity into the market, let’s say that it puts money in lenders’ pockets so they are more willing to lend again to companies and businesses. So we come back to the above mentioned mechanism: consumption boosts, inflation raises and new jobs are created. Thus QE reactivates the economy (at least it should).

There is a downside of QE. When the ECB massively buys bonds, the price of the bonds increases because demand is higher. At the same time, the yields or return interest rates for these bonds decrease because it is so easy to place them in the market, so again because of high demand. Therefore investors get less return for their investment.

All in all, we can say that QE is an extraordinary measure to achieve price stability and boost the economy. Of course, central banks have to be really careful when it comes to QE because it could easily lead to hyperinflation. On the other hand, a small QE would not have the desired effect in the economy. And knowing what is too little and what is too much is not an easy task.

Further reading

ECB Press release 22 January 2015 – ECB announces expanded asset purchase programme:
http://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html

Financial Times Lexicon: Quantitative Easing:
http://lexicon.ft.com/Term?term=quantitative-easing

About the author

Isabel Mateo is a specialist in Communication and Economic and Financial Affairs. She has worked for the European Central Bank Press Division. At the moment, she works for the information service of the European Commission dealing with economy and finance public enquiries.

Footnotes

1.The Federal Reserve (US central bank) mandate includes maximum employment, stable prices, and moderate long-term interest rates.
2. Well, as a matter of fact, they can as the ECB has recently proven but this is kind of rare and it only applies to certain rates. If you are interested, you may read more here:
https://www.ecb.europa.eu/home/html/faqinterestrates.en.html
3. The EU Treaties prevent the ECB from buying bonds in the primary market, that is, in public debt auctions.

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