What is quantitative easing?

Key Points

• Quantitative easing is a monetary policy tool central banks use to stimulate lagging economies.
• QE involves creating central bank reserves and using them to purchase fixed-income assets on the open market.
• QE is a relatively new policy, and its effectiveness and consequences are still heavily debated.

"QE" or "money printing" are terms often used in financial circles to refer to one of the Federal Reserve's most powerful monetary tools. 

What does QE stand for? That would be quantitative easing, used when Fed officials want to stimulate demand in a slow-moving economy. However, some officials and investors criticize QE for its unintended consequences and a spotty record of achieving its goals. In this article, you'll learn the quantitative easing definition, the benefits and drawbacks of the policy and its use history through a few historical examples.

Introduction to quantitative easing

The Federal Reserve has a dual mandate of stable prices and maximum employment and uses monetary policy tools to meet those goals. One of those tools is quantitative easing or QE. 

What is QE? Quantitative easing, or QE, is when a central bank creates reserves on its balance sheet and uses them to purchase financial assets. It's a proven tactic the Federal Reserve uses to influence monetary policy. The goal is to send new money into the economy through these asset purchases, which, in theory, should stimulate the economy by encouraging lending and borrowing.

While you may be disappointed to learn there isn't an actual printer spitting out $100 bills at the Fed, the tools of QE do increase the supply of money as reserves are created and exchanged for financial assets, such as U.S. Treasuries or mortgage-backed securities (MBS). Fed quantitative easing occurs during periods of economic stress, like the Great Recession or the COVID-19 pandemic. 

When the economy falters, spending slows, lending standards rise, and businesses are reticent to borrow. By purchasing assets, the Fed hopes to stabilize market liquidity and keep interest rates down, theoretically encouraging banks to lend and businesses to borrow. Of course, things don't always happen how they "should" regarding markets and the economy.

Historical context

Americans became familiar with the meaning of QE during the Great Recession, but monetary easing has been a policy tool used by the Central Bank of Japan for far longer. You can trace QE-like policies back to ancient Rome, where an economic crisis in 33 A.D. led to the Emperor creating interest-free loans.

The first modern iteration of QE occurred in Japan in 2001. After introducing negative interest rates in 1999, the Bank of Japan (BOJ) needed an additional tool to create inflation. The BOJ purchased large government debt in March 2001 to promote bank liquidity and lending. The policy was small compared to future iterations and was phased out in 2006

The largest implementation of QE occurred in the aftermath of the Great Recession and the subprime credit crisis in 2007. As global economies buckled, the Federal Reserve and other central banks began massive open market operations to purchase government and mortgage-backed debt from financial institutions and investors.

QE reappeared in 2020 as the COVID-19 pandemic threatened to stall global economies again. Only this time, the Fed's aggressive monetary policy was matched with a large fiscal response. Not only did the Fed embark on more asset purchases, but the Treasury sent direct payments to citizens and offered forgivable loans to businesses.

Objectives and purpose of quantitative easing

To fully answer the question “What is quantitative easing and tightening?”, we need to discuss the purpose and mission of the Federal Reserve. Created in 1913 through the Federal Reserve Act, the Fed's initial purpose was to secure the U.S. banking system, which panics and bank runs had besieged in the previous decades (specifically the Bank Panic of 1907).

The Federal Reserve Act established a central bank of the United States. It also introduced a new elastic currency called the Federal Reserve Note, which you can still see printed on every dollar bill in circulation today. Additionally, charter member banks were established throughout the country to expedite currency circulation and improve access to loans and financial services.

The central bank's role in economic policy has changed over the decades. In 1977, the Federal Reserve Reform Act established what's known as the "dual mandate" — stable prices and maximum employment became chief objectives for Fed governors. To ensure price stability and employment, the Federal Reserve can adjust the Fed Funds rate, influencing interest rates throughout the country.

Through quantitative easing, Fed officials have an additional way to support markets and the economy. Even when interest rates are near zero, the Federal Reserve can continue to ease conditions by purchasing assets such as U.S. Treasuries or mortgage bonds. These purchases boost liquidity, which often dries up in public markets during times of crisis. QE and low interest rates backstop the financial system and ensure lenders and borrowers continue transacting.

How quantitative easing works

Answering the question, "What's quantitative easing?" is one thing; knowing how it works is something else. Here's quantitative easing explained in step-by-step fashion and its effects on various parts of the money markets and economy.

Bond purchases

In the two most recent examples of QE, the Federal Reserve purchased large amounts of U.S. Treasuries and mortgage-backed securities. How is this process achieved? To purchase these assets, the Fed must create reserves on its balance sheet as liabilities. The Fed uses these reserves to purchase bonds on the open market, with the bonds residing on the Fed's balance sheet until the end of the program. Treasuries and MBS get the headlines, but the Fed's balance sheet also consists of loans, central bank liquidity swaps and repurchase agreements.

Impact on interest rates

The QE definition above is far from an all-encompassing view of monetary policy. For example, if the Fed Funds rate is near zero, the central bank will further consider QE asset purchases to aid markets. This results in more downward pressure on interest rates, but government bonds aren't all issued with the same maturity and yield rate. 

The Fed must consider short- and long-term interest rates, so yield curve control is another monetary policy tool. The yield curve is the difference between long-term and short-term rates. A central bank seeking to control that curve would purchase bonds with long-term maturities to smooth long-term rates.

Effects on money supply and inflation

Increasing the supply of money has consequences. The Federal Reserve (and most central banks) set their inflation target at 2% annually and use monetary policy to achieve this objective. When economies buckle, inflation tends to fall as consumers cut back on purchases and demand dries up. QE stimulates demand through liquidity infusions but can lead to high inflation. This scenario played out in 2021 in the aftermath of the COVID-19 pandemic. It can also fail to achieve its goals, as inflation remained well below target following the Great Recession despite unprecedented asset purchases from the central bank.

Tools and strategies of quantitative easing

How do central banks decide which QE financial strategies to implement? Here are a few thoughts and discussions that officials must engage with before enacting their policies.

Types of assets purchased

Since the Fed Funds rate is the preferred tool for influencing short-term interest rates, tools like QE focus on long-term interest rates. An emphasis on long-term rates means the Fed purchases fixed-income assets with long-dated maturities. 

For example, in response to the Great Recession, the Fed wanted to bring down long-term rates, especially mortgage rates. In November 2008, the Fed purchased $600 billion worth of mortgage-backed securities and obligations from government-charted mortgage lenders Fannie Mae and Freddie Mac. Then, in March 2009, the central bank purchased another $300 billion of long-term Treasuries to support troubled credit markets.

Forward guidance

Public companies aren't the only ones who issue guidance in their quarterly reports. The Federal Open Market Committee (FOMC) is like the C-suite of the Federal Reserve, with 12 members who meet eight times per year. During these meetings, each member presents their economic projections and discusses how to use monetary policy best. 

These meetings have public transcripts, which allow companies and investors to forecast how the economy and policy might unfold. Through discussion of their intentions, the Fed can influence markets and the economy without actually lifting a finger.

Exit strategies

The inverse of quantitative easing is quantitative tightening. Quantitative tightening occurs when long-term rates rise as the Fed begins to sell assets off its balance sheet back into the public markets. Tightening decreases the money supply as bonds are exchanged for reserves, which are then retired from the market. 

Qualitative easing can also be a policy tool but refers to asset allocation changes on the balance sheet rather than increases or decreases in holdings.

Quantitative tightening occurs in two ways:

• Bonds are sold back to the market
• Bonds reach maturity and aren't replaced with new assets

Either method reduces the holdings on the Fed's balance sheet. This tactic is known as "normalization." Tightening also differs from tapering, which means slowing asset purchases instead of reducing balance sheets.

Consequences and criticisms of quantitative easing

Like any economic policy, QE has predictable and unpredictable consequences. Here are a few issues critics have raised about this central bank policy.

Economic consequences

Easy money policies may stimulate growth and investment, but negative externalities also exist. Since the Fed exchanges reserves for assets like Treasuries and mortgage bonds, it relies on the financial sector to return that money. This inefficient mechanism may increase income inequality as money doesn't always reach the most needy. Additionally, critics assert that QE can lead to asset bubbles and cause inflation without corresponding growth.

Policy effectiveness

What does QE mean for most Americans? As bond yields dropped in 2009, stocks became more attractive, and U.S. equities saw a nearly decade-long bull market following the Great Recession. Asset holders benefitted, but low yields hurt savers and those on fixed incomes like retirees. 

Additionally, there's still a lot of debate over whether QE influences inflation. St Louis Fed economist Stephen Williamson issued an article in 2017 showing how QE failed to generate inflation in Japan in 2013. He also highlighted Canada and the U.S. having similar GDP figures following the Great Recession despite minimal Canadian asset purchases by their central bank.

Historical examples of quantitative easing

QE is a relatively new addition to the monetary policy toolbox, so historical data is limited. The Federal Reserve has used open market operations for QE in the face of two crises: the Great Recession and the COVID-19 pandemic.

The Great Recession

When the subprime mortgage market exploded and sent the global economy into chaos, the Federal Reserve engaged in modern QE for the first time in history. In addition to dropping the Fed Funds rate near zero, the central bank bought billions of Treasuries and mortgage bonds to reduce long-term rates further (like the 30-year fixed mortgage rate). The Fed also directly assisted troubled banks like American International Group Inc. NYSE: AIG and facilitated the sale of Bear Stearns to JPMorgan Chase and Co. NYSE: JPM.

Global implementation

While quantitative easing started in Japan, it is now a tool used to some degree by central banks in developed nations across the globe. People worldwide felt the Great Recession, and central banks in the U.K., Eurozone, Switzerland and Sweden have implemented QE policies. Many of these policies were revitalized when the COVID-19 pandemic hit in 2020.

Quantitative easing effectiveness continues to be debated

In modern terms, QE is new, and data on its effectiveness (and consequences) remains limited. Some evidence suggests the policy achieves its main goals, while other data points imply that its scope is limited and drawbacks outweigh the benefits. The truth is likely somewhere in the middle, especially when dealing with something as large and complex as a developed nation's financial system. But regardless of the debates, QE as a policy is likely here to stay and will remain one of the primary tools central banks use to fight recessions and deflation.