Quantitative Easing – What you should know about it!

On 22nd January 2015, European Central Bank announced its plan to revive Eurozone’s stagnant economy agreeing to pump in €60 billion ($69 billion) per month thus grabbing headlines. Quantitative Easing (QE) is not an unfamiliar policy in the financial world.  When short-term interest rates are closest to zero and the central bank can no longer ease policy by simply adjusting the price of its reserves, then it aims to adjust the quantity of reserves.

On 22nd January 2015, European Central Bank announced its plan to revive Eurozone’s stagnant economy agreeing to pump in €60 billion ($69 billion) per month thus grabbing headlines. Quantitative Easing (QE) is not an unfamiliar policy in the financial world.  When short-term interest rates are closest to zero and the central bank can no longer ease policy by simply adjusting the price of its reserves, then it aims to adjust the quantity of reserves. It is more of an extension of Open Markets Operation, which basically involves buying and selling of Treasury Securities from private dealers putting money in or taking money out of the system. An increase in the supply of money lowers interest rates and vice-versa. But QE differs from Open Market Operations in a few ways:

• The scale of QE is much larger than Open Market Operations. 

• In case of Open Market Operations, interest rate cannot go below 0%. But Quantitative Easing is brought into action once the short-term interest rates are so close to zero that they cannot go below.

• Open Market deals in short-term bonds whereas QE focuses on long-term bonds with maturities of several years. 

Impact of QE on the economy

Quantitative Easing is an expansionary monetary policy where the central bank prints more money (electronically) and buys long-term government and private bonds (maybe from banks), which increases the cash circulation in the system in order to lower cost of borrowing (long term interest rates). Once the interest rates are reduced, businesses are encouraged to borrow and invest in projects (building factories, buying raw materials, hiring manpower etc.), which in turn help in boosting economic growth.  The situation creates a win-win situation that also encourages consumer spending breathing life into a sleeping economy, increases investment, employment and consumption.

Careless Quantitative Easing

The downside of QE could be that increase in the money supply, if not monitored, could lead to an increased inflation in the long run, where more money chases the same number of goods and services. 

Quantitative Easing history across the world

Over the past few years, QE was used as a long-term survival strategy for three major markets of US, UK and Japan. China too, adopted QE via soft loans to the banking sector.

Japan’s QE in 2001

Quantitative Easing was first used in Japan in 2001 for a period of five years mainly due to its long stagnant economy. The Bank of Japan tried to revive the world’s third largest economy that had been facing a history of deflation. Japan kept printing more yen and wanted to get it into circulation. They wanted to increase the quantity of money at any cost. Japan’s use of quantitative easing in the early 2000s was seen as largely unsuccessful, with banks refusing to lend money despite the extra liquidity. 

In 2013, they unleashed a massive QE program worth $1.4tn under Abenomics. Under that QE plan, the Bank of Japan (BoJ) vowed to buy ¥7tn yen (£46bn) of government bonds each month using electronically created money. Further, in October 2014, the BoJ increased it monetary base and revealed that it would raise the amount pushed into the system each year to $724 billion (¥80tn) as compared to ¥60-70tn the previous year. 

USA’s QE in 2008

2008 marked the implementation of QE for US. The aim was to revive the world’s largest economy from the financial collapse. The securities covered by these actions ranged from treasury bonds to mortgage-backed securities. The second round of QE happened in November 2010 with purchase of $600 billion in Treasury securities by the end of the second quarter of 2011. In 2012, the U.S. Federal Reserve intervened further and kept the markets prepared for a third round called QE3 with an operational twist. The idea behind the exchange was to flood the market with the former, and thereby cause short term interest rates to rise; by buying up longer term securities they would also do the opposite, causing long term interest rates to fall. Purchases were halted on October 29, 2014 after accumulating $4.5 trillion in assets. Did it work? US unemployment fell sharply after QE started and the US economy proved relatively solid, but growth rates that were small, were considered significant.

UK’s QE in 2009

The Bank of England launched QE in March 2009 and bought £200bn of assets. In 2011, it again created an additional £75 billion to avoid double-dip recession. By 2012, it had announced a total of £375 billion. Did it work? Well, UK had benefited households differentially according to the assets they hold with richer households have more assets. In 2014, it was the fastest growing G7 rich nation.

Eurozone’s QE in 2015

In 2012, ECB President Mr. Mario Draghi had expressed that he would do “whatever it takes” to preserve the euro. But after years of trying to correct the economy, interest rates still remained as low as 0.05%. The European Central Bank (ECB) tried to boost lending by offering cheap loans to banks but when inflation turned negative for the first time in more than six years in December 2014, Mr. Mario Draghi decided to use Quantitative Easing (pumping a total of €1.14 trillion) until March 2016. Inflation in the Eurozone is -0.2% when compared to its target of 1.9% so little inflation might do more good than harm to Eurozone. If the Eurozone is stuck in deflation for too long it could delay spending decisions leading to stagnation and falling prices. Currently, the money in the Eurozone seems to be stuck in the banks, which are reluctant to lend to uncertain markets.

Will QE work in Eurozone?

Eurozone comprises many countries with a common currency and policies. In the past, QE has been tried and tested on individual countries. One major drawback could be that each country may hold a different perspective towards Quantitative Easing and Germany is a fine example. Germany is of the opinion that for heavily indebted economies of Italy and Spain, QE could slow down the structural reform across Europe. But here is the catch: individual central banks will be liable for losses on 80 per cent of the bonds bought. That way, Germany wouldn’t have to pick up the whole bill for any losses on say, Spanish bonds. Greece and Cyprus are excluded due to their debt not being “investment grade.”

According to Forbes, around €275bn will be flowing into Germany – a country that is perhaps is in the strongest position in Eurozone and needs liquidity the least. Economists stand mixed about how QE can help the Eurozone. Many refer to the 1920’s, when hyperinflation caused prices to rise many times over in five years. QE is not any different than what the ECB has already being doing so far except for the injection of money on a larger scale. Some analysts say that QE could only bring a small difference to Eurozone. At the same time more optimistic economists think it will help European crisis even if many don’t approve of the programme. 

Quantitative Easing has faced mixed reviews in most of the countries in which it was undertaken. One contribution it ends up making is improving market confidence.  Many argue that it also creates unpredictability. It can create some serious damage if banks remain reluctant to lend money to local businesses and households but show more confidence about investing in emerging markets and in non-local opportunities. 

Whether QE will be the knight in shining armor to the Eurozone or not remains a big mystery…. but if it works then it will definitely be good news for many countries.