What is Quantitative Easing and How Does it Affect Markets?
Quantitative easing, affectionately referred to as “QE”, is a term that has been widely used in recent years. In fact, more people are likely familiar with this phrase than ever before. Given its coverage in the media, and its widespread use, we felt it prudent to provide a simple explanation of what QE is and how it can affect financial markets.
What exactly is Quantitative Easing?
Quantitative easing is a tool used by central banks in order to try and boost economic activity. The way QE works may seem difficult to comprehend, but is relatively simple. To perform quantitative easing, banks purchase securities from banks (such as government bonds) and pay for these securities with electronic funds that did not previously exist. In other words, with the click of a button, the central bank is able to print money out of thin air. This newly created money is designed to boost the amount of bank reserves. The bank, in turn, is then supposed to make more loans because it has more capital in reserve. The bank may also purchase new assets to replace those sold to the central bank. It is thought that these bank purchases, as well as higher loan activity, will cause stock prices to rise and interest rates to fall.
QE may be used more as a method of last resort. Under normal economic conditions, central banks may be able to control the money supply through interest rates. As the economic crises began to take hold in 2008, central banks slashed interest rates to zero or near-zero levels. That, however, did not prove to be enough. QE then began being used as a tool to get banks to lend more and spur economic activity.
It is not yet known whether quantitative easing was truly effective or not…
Some would argue that QE did, in fact, boost output and lending while other analysts believe that is was largely ineffective.
Perhaps even more important now is how central banks begin to step back from such measures. If the additional cash that has flooded markets began to circulate more rapidly, it could spur inflation. In addition, once central banks begin to unwind their balance sheets (selling the assets they have accumulated) interest rates could potentially soar and cause any economic recovery to falter.
It remains to be seen just how central banks will accomplish the unwinding of balance sheets, and it is a cause for concern.
Some analysts believe that the multi-year rally seen in equities has been a result of QE and low interest rates. QE may boost demand for stocks and other assets, especially in the face of low interest rates.
While that may very well be true, and QE may drive risk-taking and investment, it has not been proven. Just look at Japan, or the fact that several rounds of QE in the U.S. have thus far not been able to ignite inflation.
QE is ongoing in some nations, with the European Central Bank recently announcing another, larger round of bond purchases.
Time will tell just how effective, if at all, QE is. In addition, stepping back from QE may prove challenging for central banks, and could potentially cause higher interest rates, lower stock prices and risk-aversion while dampening economic activity.