ODI Explains: What Quantitative Easing is All About
Quantitative
easing, QE, is a monetary policy means to an end – stimulating growth in the
economy. It is an extraordinary tool employed by central banks to boost an economy
when tempering interest rates yield little or no desirable results. In order to
maintain satisfactory economic growth rates, a central bank may decide to raise
or lower interest rates. Lowering interest rates tends to lower savings and encourage
consumption spending and investment spending. In the event that a lowered or close-to-zero
interest rate does not rouse aggregate demand as expected, a central bank may
decide to ‘pump’ money directly into the financial system; this is what QE is
about.
Ordinarily, a
central bank may adjust interest rates to put a check on inflation. For
instance, when corporates scale back on investment due to uncertainties about
the future, a central bank can reduce its lending rates. A reduction in the
rate at which banks and other financial institutions may lend from the central
bank lowers banks’ funding costs. Consequently, this should encourage banks to
make more loans available to consumers and investors for consumption and
investment purposes, thereby help keep or bail the economy out of recession. On
the other hand, a central bank would raise its rates if credit is over-abundant,
spending is mounting and inflation out of control.
However,
there are situations during which a slash in interest rates may not promote an
economic recovery as desired by a central bank. This is often the case during a
recession or in periods subsequent to a recession. During a recession, a central
bank may resort to QE. For instance, the US Federal Reserve Bank, Bank ofEngland and recently the European Central Bank resorted to QE as an
extraordinary intervention to promote economic recovery following the 2007/08
crisis. In early 2000s, The Bank of Japan used a QE approach to stimulate the
Japanese economy after the lost decade.
Now what is QE
and how does it work? First, we have established that the purpose of QE is to
provide a knock-on boost to the economy. QE involves central bank buying
assets, usually government bonds from banks and other financial institutions,
with money it electronically creates or ‘prints’. By purchasing bonds with new
money, the central bank increases the total amount of funds available in the
financial system. Increase in funds boosts the capacity of financial
institutions to lend more to corporates and individuals. Increased credit
availability tend to lower interest rates across the economy. In addition, when
government buys up bonds, bond prices are expected to rise and bring about a reduction
in the rate of return accruable to investors for loaning money to government. Lower interest rates should allow businesses
to invest and consumers to spend more. Ultimately, increased consumption and
investment spending will provide a boost to the economy.
QE is
obviously the best and only bet for an economy practicing fiscal consolidation.
Dependent on the state of the economy in question, a central bank may carry out
several rounds of QE until it achieves its growth rate and/or inflation target.
QE is considered beneficial because it boosts liquidity in the economy when
there is a shortage. Increased liquidity tends to boost investor confidence and
potential for increase in household consumption expenditure. During a round of
QE funds are available at no costs to the government nor its tax payers.
Nevertheless,
it is pertinent to note that there are several risks to and critiques of QE. First,
large corporates usually have easier access to borrow from bond markets and
tend to be the greater beneficiaries in the QE process. There are fears that
micro small and medium enterprises, MSMEs, most of which are financially
excluded may not directly benefit from QE. Of course the central bank can
advise banks and other financial institutions to fix a portion of credit available
to these category of enterprises. Owing to the fact that MSMEs are largely
engines of inclusive growth for developing countries as well as developed
countries, it is important that the QE has a trickling down effect on these
group of firms.
Another
critique of the QE option is that it can make an economy susceptible to a
liquidity trap when banks hold off on making credit available in the domestic
economy and rather speculate on cross border transactions which have hope of higher
and quicker returns. Therefore, in order to spread the effect of a QE, the
central bank may consider providing lending support to some or all categories
of firms in the real economy. In cases where a QE working together with a
fiscal consolidation has not boosted investor confidence and consumption
expenditure, fiscal policy may serve to bridge the gap that QE fails to fill in
the economy.
There are
several questions regarding the effectiveness of QE in the past which empirical
investigations can provide answers to. For instance, retrospective studies can
seek to answer the question: what are the adjustment and shock effects of a QE
exercise on components of aggregate demand in an economy? What factors contributes
to the inclusiveness of growth stimulated by a QE episode?
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