What is quantitative easing?

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Quantitative easing, or QE for short, is complex. Let’s try and simplify it for everyone.

A quick caveat: I’m just taking an overview here. This isn’t the deeply in-depth description your uni professor might be looking for. This is aimed at a high school economics audience.

We’re starting with central banks. If a central bank wanted to speed up or slow down an economy, to achieve its goal of price stability (keeping inflation low, often within a target band), the central bank would affect money supply in the overnight markets. This would lead to changes in the general level of interest rates, economic activity and inflation.

For instance, if an economy has very low inflation, the central bank there might cut the official interest rate (in Australia this is the cash rate; in the US this is the Fed funds rate). But what if the central bank runs out of ammunition and doesn’t have room to cut rates further? What if rates are 0%, or even negative, and the economy hasn’t responded?

Let’s use an example taken from The Economist. During the Global Financial Crisis (or Great Recession for our American readers), America’s Federal Reserve and the UK’s central bank, the Bank of England, slashed rates to spark economic growth. But! Despite rates reaching close to zero, their economies didn’t respond. 

This is where quantitative easing (QE) comes in.

When monetary policy is not effective enough, central banks think about QE.

Here’s the broad process of QE:

  • Conventional monetary policy is not working

  • Central banks buy securities, such as government bonds, from banks (outside of regular monetary policy transactions)

  • This increases money supply in the economy which will push down the general level of interest rates

  • The lower interest rates will encourage individuals and firms to borrow more, save less, and increase consumption and investment (components of aggregate demand)

  • Economic growth and inflation will increase.

(Again, please note, I’m simplifying this just to share the main concepts at work. If you want to go deeper on this process, particularly how buying bonds will actually reduce the general level of interest rates, try here and here.)

Does QE involve central banks ‘printing money’? Where does the money come from for central banks to buy assets from the banks? This is complex and will be covered in a future blog post. Let’s keep it simple for now.

In September 2019, the European Central Bank (ECB, the EU’s central bank) implemented a form of QE. From November 2019, the ECB will buy €20bn worth of bonds every month — with NO end date to the policy. 

Does Australia need to introduce QE? Reserve Bank of Australia Governor Phillip Lowe has said that the RBA would consider cutting official interest rates to zero AND introducing QE...but he believes that at this stage, as of September 2019, it is unlikely.

And another thing worth thinking about. QE is unconventional. It’s not typical, it’s like an extreme form of monetary policy. So, if central banks are thinking about taking extreme action on monetary policy, why aren’t governments doing the same with fiscal policy?