In honor of tomorrow morning’s upcoming jobs numbers, here is the dummy’s guide to quantitative easing. Rely on this at your own risk!
What is Quantitative Easing?
QE is the creation (“printing”) of money to buy assets by central banks. It’s used when “open-market operations” or the buying or selling of securities by the central banks loses its punch as a tool to encourage spending and investment, because interest rates have no more room to fall.
What are the desired effects of QE?
Investors sell securities to the central banks, taking those proceeds to buy and boost other assets, such as stocks, bonds, and foreign assets. Increases in bond prices lower bond yields, encouraging borrowing. Higher equity prices increase consumption as people feel richer, boosting demand and investment in the real economy. Foreign assets weaken our currency, boosting exporters and consequently giving some tailwind to the domestic economy.
QE can also lower the government’s borrowing costs if the central bank buys government debt. It also ties the government in with bond investors to the promise of keeping rates low, as the central bank exposes itself to a rise in interest rates by holding the portfolio of securities that it has bought.
Does QE work?
Economics always has the counterfactual problem, since we don’t what the “but for” world would have looked like. But research tends to support that it has an effect, at least initially. See this article for a summary of the research.
What are the risks of QE?
Risks include distortions in the market for sovereign debt, i.e., the complaint that governments lose the discipline of private bond markets in their spending, and distortions in private markets. Certain economists have been screaming that the printing of money inevitably leads to inflation, although there has been no evidence of that yet, and economists such as Paul Krugman and others stridently disagree. It’s not clear whether there is any research or evidence about the risks, so even a bit more than the benefits of QE, the risks are theoretical.
What do you do after QE hits diminishing returns?
Since negative nominal interest rates are impractical or unrealistic, economists believe you should induce higher-than-usual inflation. Thus, even if the nominal interest rate stays at zero, higher inflation results in a negative real interest rate and gives a higher stimulative effect to the same nominal interest rate. Of course, purposely fueling inflation is something that many economists and policymakers find an uncomfortable course of action for fear — whether real or imagined — that once the fire of inflation is lit, the central bank may not so easily be able to bring it back under control so easily.