Finance Glossary: Quantitative Easing

by Johnlabunski Labunski John Labunski Dallas

Quantitative Easing (QE) is an expansive and unconventional form of monetary policy . It is used by central banks as a method of rapidly increasing the availability of money and stimulating a country's economic activity.

In summary, central banks, such as the ECB (European Central Bank), buy government bonds and bonds, with the aim of putting new money into circulation and reducing interest rates. This, consequently, should stimulate an increase in consumption and investments.

Therefore, knowing how Quantitative Easing works can be useful to understand what the consequences are on the economy and the effects on citizens and businesses. Let's deepen immediately.

How Quantitative Easing works

Quantitative Easing is a fairly aggressive monetary policy action, with profound effects on the delicate balance of a country's economy. In fact, it leads to an increase in the monetary base available to the banking system, with repercussions also on inflation.

The purpose of QE is to reduce the value of long-term debt by injecting new money and devaluing the currency. However, to better understand how this works, and the reasons that can lead to this process, it is necessary to clarify the role of central banks.

What a central bank is and what it does

The central bank is a public institution that performs the function of a leading actor in monetary policy in a particular country or group of countries. Its primary objective is to control the supply of money in circulation in an economic system, to stabilize its prices with appropriate strategies and tools.

Hence, a central bank pursues predetermined goals of growth, inflation, etc., orienting the credit system and the behavior of economic actors. To carry out its functions, the main actions it can take are:

Expansive, to stimulate the economic system in the phases of slowdown and recession;

Restrictive, to cool the excessive economic exuberance and the consequent risk of inflation.

However, starting with the Great Crisis in Japan in 2006, followed by England in 2008, up to Europe in 2015, central banks have introduced extraordinary tools to achieve their goals. Among these, we find Quantitative Easing, also called “quantitative easing”.

Unlike in the past, in addition to normal operations, central banks also intervene on the secondary market and buy bonds of all kinds and maturities. This approach has become the norm, even more so in recent years, following the COVID-19 emergency. For example, the ECB has launched an extraordinary purchase program called PEPP (Pandemic Emergency Purchase Program), precisely to contain the effects of the pandemic.

Why central banks use QE

Imagine. What could a state do that needs liquidity to support its economy? Issue securities that can be purchased by banks, citizens and businesses. These bonds have a deadline, within which the State undertakes to return the money to the buyers with the related interest. In the meantime, however, it acquires the liquidity it needs.

Those who buy government bonds can:

Exploit them as an investment and wait until the set deadline, to profit from the interest accrued;

sell them on the financial market, if convenient. Or, to buffer any losses if there is a risk that, at maturity, it will not be possible to recover the investment.

So far, nothing new. Except that, usually, among the main buyers of government bonds, and not only, there are commercial banks, which often find themselves in possession of large amounts of fixed money. Pay attention to this aspect, as it is fundamental in triggering a Quantitative Easing action .

Indeed, when central banks want to facilitate loan applications and incentivize investment, they know where to turn. They propose to commercial banks the purchase of their financial assets with high ratings, including both bonds issued by governments, such as BTPs, and by private companies.

Assets are purchased with liquidity issued by central banks, providing new money to the banks themselves. Consequently, the latter can facilitate access to credit for citizens and businesses, by borrowing money at lower interest rates.

So, in summary, a state can sell its securities to acquire the liquidity necessary to give new life to activities and services. Among the major buyers are commercial banks, which find themselves with "money tied up in bonds".

Therefore, when the central bank of a state wants to facilitate loans and investments, to give "breath" to its economy, it does nothing but buy back its securities, and other assets, from the banks. In this way, it puts new money into circulation. Here is Quantitative Easing in action.

However, QE is a risky monetary operation, as it carries a number of consequences that need to be weighed and managed. We are about to see them.

Effects of Quantitative Easing

Every action is followed by a reaction. And in the financial field there is no escape from this maxim. Quantitative Easing has a significant impact on the economic context in which it is implemented, with chain consequences on the cost of living and purchasing power:

injecting new money into circulation reduces the value of the currency;

the devaluation of the currency leads to an increase in demand and leads to an increase in prices, which lowers the rates of return on bonds and, consequently, also the interest rates of mortgages and loans;

Rising prices triggers the rise in inflation, which in turn contributes even more to the rise in prices.

Therefore, the objective of a Quantitative Easing action should be to increase the level of consumption and investments. Indeed, pushing prices high enough to impact inflation can avert the danger of deflation .

Deflation is far more fearful than inflation. It can trigger a very damaging spiral for the economy: it slows down purchases and investments by individuals and companies, as it lowers prices and induces the postponement of any growth action. As a result, demand falls and producers of goods and services are forced to further reduce prices to encourage buying.

When deflation is in place, companies lose large chunks of revenue, cut costs that affect their balance sheets, and lay off employees, increasing unemployment. Furthermore, by not investing in their growth, they stop demanding liquidity from banks. In short, a chain of events that casts a shadow on the economic stability of an entire nation.

Now that we have a fairly complete vision of a very complex scenario, which certainly deserves further study, the question that everyone is asking is: does Quantitative Easing work?

Quantitative Easing: Does It Really Work? And what is its impact on the markets?

Since central banks began operating with expansionary and aggressive monetary policies, such as Quantitative Easing, the immediate effects have been:

· increase in liquidity in the economic system;

· artificial lowering of rates;

· repercussions on the performance of the financial markets.

The compression of yields for bond investors is now an established fact, and is unlikely to change anytime soon. Instead, on the equity front, Quantitative Easing resulted in the coexistence of persistent and surprising rises, with violent and sudden falls.

We will need to be more careful and live with the unpredictable behaviour of the markets. However, the knowledgeable investor already knows that he will never find confirmation of his assumptions in the markets. He is ready to adapt, to grasp the fundamental rules and to act according to his own financial objectives.

Through an adequate financial education and the support of a private banker with proven experience, you can acquire the necessary awareness to act consistently and safeguard your savings. Contact me without obligation. I am (John Labunski)at your disposal for a free consultation. Together we can plan the correct management of the investments necessary to protect your financial future.