What is Quantitative Easing? What are its Pros and Cons?

Quantitative easing has become a buzzword of the world economy, thanks to the major political changes in the US and Europe fueling a new age of economic change. The central banks of various countries hold the power to modify the supply of money in the economy to ensure that inflation remains in check, lending is supported and the prices of household goods and services do not increase beyond a certain point. The banks use several instruments and policies to modify these figures based on several economic indicators. One such policy is quantitative easing. We will be telling you everything you need to know about this policy below.

What is quantitative easing?

Quantitative easing is a part of a central bank’s monetary policy. The quantitative easing method, as the name suggests, helps in bringing more money to the economy. The central bank does not use this method often and this move is considered rather unconventional. However, when used, QE will help in lowering the interest rates of the economy. The central bank purchases securities from the market, which may include government securities as well. This brings the interest rates down and the money supply in the economy increases. Financial institutions have more money as their securities have been sold and they can now promote lending.

As we mentioned, it is not a very common move. Quantitative easing is mostly used when the interest rates of short-term securities are approaching zero, which signals that the economy has become stagnant. The banks do this to avoid printing new notes and still encouraging financial institutions to lend more. In essence, the central bank takes the responsibility to increase money in the market by purchasing securities and parting with its own cash.

Remember, this is all electronic cash and does not exist in the form of banknotes. It only appears in the banks’ balance sheets. As new money pours in, the bank reserves increase in size. Financial institutions, that have recently sold their assets to the central bank, now find more money to buy fresh assets. Consequently, the interest rates are lowered and the stocks get a boost. Investment increases in the market, lending by banks increases further and the stagnant economy gets a kick start.

Quantitative easing is being adopted by central banks of developed countries around the world since the 2008 financial crisis. The balance sheet of the Federal Reserve increased 4 times from 2007 to 2015, amounting to a staggering $4 trillion due to QE. However, this step has successfully kept the interest rates of corporate debt as well as mortgages low by sending a clear signal about the central bank’s serious to curb deflation.

Pros of QE

Quantitative easing has helped in securing growth in mature and developed economies of the world moving towards stagnation. QE is mostly complementary to lower rates of interest on Federal funds. When the interest rates on these funds are lower, banks are encouraged to lend more. However, it is possible for the economy to struggle and borrowing to go down even when the lending rates are low. This happened in the 2000s, when the US economy was struggling with Federal fund rates as low as 0.25%. Quantitative easing helps in offsetting negative market conditions that affect borrowing and creates a positive environment for businesses to flourish.

As the quantitative easing definition suggests, it helps in increasing the money supply in the market. If banks will have more money, they will lend to more businesses and this will help in bringing the economic growth back on track. Additionally, fostering business growth brings the unemployment levels down. It helps in the creation of new jobs as well.

QE helps in striking a growth spiral where businesses get more money to hire more people. These people, previously unemployed, now earn wages with which they can buy household goods. This increases consumer spending which increases inflation in the economy. With a steady rate of inflation, businesses get more boost to work harder and the economy enjoys the overall benefits of a bustling business environment.

Cons of QE

Quantitative easing may make inflation rates go high. There is not much historic evidence to prove that QE can severely affect inflation numbers and make household spending higher. However, as it increases consumer spending and allows businesses to get fresh loans from banks, it is likely that inflation numbers can go higher than what the central banks expect. Consumers may lose confidence because of a dwindling household consumption level and they may wish to curb spending, expecting more upheavals in the future.

In addition to this, we must note that this policy may create reckless lending and spending in businesses, leading to the creation of business cycles. When banks get electronic money by sale of assets (some of these could be toxic as well), they compete to lend more. As the central bank encourages lending and keeps Federal fund interest rates as low as possible, banks may indulge in reckless lending. Businesses and individuals with low credibility can also get loans now.

It cannot always be expected that loans will be given for productive purposes only. Credit cards, mortgages, and student loans will also be given freely apart from business loans. If such unchecked lending is not taken into consideration then low credibility debtors will eventually default in inflationary conditions, leading to a crisis. Businesses may also go through cycles of boom and bust, swinging from one extreme to the other. However, these effects will be visible in the long run as we still cannot quantify the effects of QE on the economy.

Quantitative easing is not a perfect policy and the real effects of this monetary policy will only be seen in hindsight, a few years from now. It is a newer method to fuel the economy and has a few unwanted consequences too. It has been noticed that the positive effects of QE are not permanent which may lead to the central banks following a series of QE incentives, just like the ECB is doing in Europe. Considering the difficult times developed and mature economies are facing, quantitative easing is unavoidable.