Quantitative Easing a quick primer... (post Federal Reserve meeting)

Interest rates in the US have been hovering near record lows for the last few months after the rate cuts of 2020 brought on by the Covid pandemic. This, coupled with record highs in the stock market and a boom in the wealth of top income earners, has fueled a huge rise in housing prices. Lowering the Fed Funds rate is not the only arrow in the government's quiver, they have increasingly been using Quantitative Easing (QE) and this has also helped to add dollars into the economy and spur economic growth. Many of my students have asked what QE is, and I thought that this could be a good time to write a quick primer. Here goes...

1.  When did it all start?

QE has been a relatively tool by central banks, with the Bank of Japan in the early 2000s after what has now been called the lost decade (of the 1990s). Since then it has been used in the US after the 2008 financial crisis and other parts of the world.

2. What is it?

Instead of using interest rates as the means to provide (or reduce) liquidity in the system, the central banks have used the quantity of money as the key lever. The central bank buys back bonds (mainly those issued by the government) from commercial banks in exchange for liquidity. Central banks focus primarily on buying longer term bonds (especially the case in Japan) but in reality they buy back a wide range of tenures to bring down rates across the yield curve. This cash is meant to then be distributed via loans and other means to corporations and individuals and in order to spur on lending, spending and ultimately lead to stronger economic growth. 

3. Did it work?

Not very well. The lost decade in Japan has actually turned into the lost 20-25 years. It's only recently that the economy has started to show some signs of life. Same in the US. Although the 2008 crisis was eventually brought to its knees by the aggressive measures by the US government the subsequent economic growth rates were rather anemic compared with previous post recession rebounds. It has helped asset prices rise a bit, but it has not lead to inflation.

4. How is this viewed?

There is a mixed view. It has helped a bit, and ultimately economic growth both in Japan and the US has been stronger than otherwise it would have been. Initially people were very weary of this tactic by the Bank of Japan, but 20 years later this seems to have become the primary tool used by central banks as the short term interest rates around the world have hovered around zero (or even negative as they are in some parts of Europe and Japan) is no longer an effective means to help economies regain growth.

5. How big of a tool is it?

In one word: Massive. It is estimated that banks in Japan, Europe and US pump in $15 billion/day.  Since the early 2000s there is an estimated $10 trillion of additional liquidity that has been infused into the global economy through QE.  It really exploded during the pandemic and the various stimulus measures announced around the world. 

5. Doesn't all of this extra cash inflation?

Traditional economists have feared that all of this additional liquidity in the system would ultimately lead to inflation. QE is still a little bit of an unknown. We know how it works in that Central Banks buy bonds and ultimately long term interest rates go down. But after that we are not sure why the rates stay this low. Bernanke even joked that "it works in practice, but it doesn't work in theory" which can be a problem. As a result it's not totally clear why inflation has not picked up, although in reality inflation might not be properly calculated (that is for another blog post!). Touching upon the fact that this is a new tool, and that there is so much additional cash sloshing around, it's unclear what the true costs will be (higher rates/inflation?).

6. When will is stop?

This is a big question. We know that central banks are asking themselves when is the right time to end this and what will happen? It's anyone's guess at this point. Some things to focus on how will it affect interest rates, and won't they rise (because there won't be a force to keep them down). But they can obviously talk down the rates and be able keep them down through signaling. Won't it be a huge negative for US government as the borrowing costs will rise a lot? This is a similar case in Europe and Japan as well. So this is something that can have huge negative economic consequences. 

Bottom line is this. Although Central Banks are run by some of the best and the brightest economists in the world, the fact that there are so many unknowns swirling around it does appear that one thing is certain. In the land of the blind, the one eyed person is king. Let's see how this all plays out, and we will learn a lot more about QE, whether it works and it's long term impacts on the global economy, over the next few years.