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What Is Quantitative Easing?

Quantitative easing, more commonly known as QE, is a form of monetary policy conducted by central banks to stimulate a country’s economy by providing liquidity to the banking system. QE is a relatively new concept, first initiated by Japan’s central bank (BOJ) in March 2001. Japan was in the middle of the country’s worst financial crisis since the Great Depression. Consequently, it was in desperate need of an innovative solution to its economic problems. The BOJ unveiled a radically new program that involved purchasing large quantities of government bonds from commercial banks and other financial institutions. This became known as quantitative easing (QE).

Why Do We Need Quantitative Easing?

The main goal of QE is to increase economic activity by aggressively adding reserves to the country’s banking system. As we mentioned, reserves are added to the banking system through the purchase of government securities by central banks. Of course, simply adding reserves to the banking system will not “magically” increase economic activity. The banks play a major role in this process by lending the excess reserves to consumers and businesses. Without cooperation from the banks, QE becomes completely ineffective.

Also, QE contains a bonus of reducing long-term interest rates. By purchasing large quantities of government bonds, central banks decrease the overall supply of these securities, increasing demand along the way. As you know, all debt instruments have two main components — a price and an interest rate. Using the inverse relationship between these components, central banks initiate a decline in long-term rates by implementing their QE program. Of course, this simplifies borrowing funds, which helps to stimulate economic activity.

In response to the 2008 global financial crisis, the majority of G20 central banks released their version of QE. They followed the playbook of the BOJ from 2001. For the past 13 years, all major central banks have been in a continuous loop of quantitative easing. These monetary authorities have substantially increased their balance sheets by purchasing government bonds from banks and other financial institutions. Interest rates have been hovering near 0% since 2008.

Measuring The Success Of QE

Has quantitative easing produced the desired results? Is QE considered a successful central bank monetary program? These are difficult questions to answer because QE has produced varying results for different groups of people. The results have been mixed, at best. Many investors and financial professionals believe that QE has been a raging success while others believe that it will go down in the history books as an abject failure.

Professional Investment Community

In terms of the professional investment community, QE has generated incredible results because it has been the driving force behind the greatest stock market rally of all time. Global equity prices have risen dramatically during the past decade in response to aggressive bond purchasing programs, which have pushed interest rates to 0%. Some countries have experienced negative interest rates. Based on historical data, low-interest rates are very bullish for stocks because it forces investors out of the bond market and into the stock market. This explains why stocks have experienced a record-setting bull market since 2008.

Individual Consumers

What about individual consumers and the broader global population? Has QE provided any relief to this sector of society? Economic historians and research institutes have concluded that central bank QE has failed to provide any economic benefit to individual consumers. Why has QE been unable to improve the lives of consumers, the working class, self-employed workers, and small business owners? Because the overwhelming majority of funds received by commercial banks through quantitative easing never made their way into the hands of consumers in the form of bank loans.

As we discussed, the original intent of QE was to stimulate economic activity at the consumer level. In theory, quantitative easing is an excellent approach to resurrecting the growth rate of an economy. Unfortunately, QE has one major flaw that is difficult to overcome. The stumbling block occurs when central banks deposit funds with each commercial bank through the purchase of government bonds. Central banks can’t force these institutions to disperse the deposited funds to consumers and small businesses in the form of bank loans. Instead of lending money, commercial banks prefer to hold these excess reserves on their balance sheets. Commercial banks can earn interest on excess reserves. Therefore, it’s much easier and less risky for these institutions to hoard the money received by central banks. This explains why many people consider QE to be a failure.

Wrap Up

If QE is unable to provide economic relief to the working-class population, why do central banks continue to promote this program? Because quantitative easing has provided record-setting gains for all G20 stock markets. Generally speaking, central banks believe that rising stock prices are beneficial to the overall economy. The majority of central bankers believe in the trickle-down theory, which states that profits generated from the wealthiest 10% of the population will eventually “trickle-down” to the middle class and lower class. The vast majority of stock market ownership is confined to the upper class (i.e. the wealthiest 10% of the population). Therefore, central bankers believe that they must keep stock markets elevated to maintain the trickle-down theory.

A growing number of professional economists are concerned that central banks are reaching their limit in regard to QE. Central bank balance sheets have reached unprecedented levels. If QE continues at its current pace, central banks will soon own 100% of all outstanding government bonds. If interest rates begin to rise, bond prices would fall and central bank balance sheets would collapse in value. This explains why QE will eventually be phased out of existence. Central banks can’t afford to jeopardize their balance sheets. As much as central banks love quantitative easing, this program can’t last any longer.

Brief Summary Of Quantitative Easing

  • QE is a form of monetary policy conducted by central banks.
  • The goal of QE is to stimulate a country’s economy.
  • QE occurs when central banks provide liquidity to the banking system.
  • Liquidity is accomplished when central banks purchase government bonds.
  • The bonds are purchased from commercial banks and other financial institutions.
  • The proceeds from the sale of the bonds are held by the commercial banks.
  • Commercial banks will loan these proceeds to consumers.
  • QE was first initiated by Japan’s central bank (BOJ) in March 2001.
  • QE contains a bonus of reducing long-term interest rates.
  • All G20 nations introduced a QE program following the 2008 financial crisis.
  • Most financial experts agree that QE has failed to produce the desired results.
  • Central banks prefer QE because it increases stock prices.
  • QE adds a great deal of risk to central bank balance sheets.
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