Everything to know about Quantitative Easing
The health and economic crisis that has arisen from the coronavirus pandemic has brought back discussion of Quantitative Easing. Despite being a recurring term in recent years, not many people understand exactly what this kind of stimulus program consists of. Quantitative easing is one of the most important monetary policies available to both the European Central Bank (ECB) and the Federal Reserve (Fed), used in recent history to confront several crises.
What is Quantitative Easing?
Before we discuss the specifics of Quantitative Easing, let's understand some basic facts related to the function of economies. For an economy to grow, it is necessary to:
- Increase production capacity
- Improve technological base
- Stimulate currency circulation
The objective of quantitative easing is to help currency continue to circulate in the context of a slowdown. It is a program to stimulate investment, spending, and consumption by offering facilities access to cheap credit.
QE, or Quantitative Easing, is an aggressive monetary policy whereby central banks buy large amounts of financial assets in an attempt to stimulate the economy by directly 'injecting' cash.
A central bank can buy financial assets and government or corporate bonds. These purchases increase the reserves of the banks, which, in turn, allow them to offer more loans. Because of this, two effects are achieved at the same time: reducing interest rates, and increasing the amount of money in circulation. The side effects are positive, in theory, as consumption increases and more jobs are created.
Quantitative easing can take several forms, depending on the assets the central bank buys, from whom it is purchased, and in what amounts.
Quantitative Easing in Times of Economic Crisis
Depending on the interest rate policies of central banks, economies can grow rapidly in a short period of time and in immense proportions. However, due to their nature, these economies require the circulation of money to be maintained over time, which is not a simple task.
What happens when people or companies no longer feel secure about their loans? Capital circulation is reduced: public spending decreases, the demand for goods and services decreases, business expansion slows down, and companies reduce their production and lay off part of their workers trying to adapt to new market conditions.
This entire chain leads to:
- Increase in unemployment
- Reduction of household income
- Less consumption within families
What happens when banks do not feel safe to lend money to their customers, either to individuals or to companies? The answer is the same as above, the circulation of money stops.
In this context, if individuals and companies stop paying their loans because they cannot afford them, financial institutions may fail. This is what happened with Lehman Brothers more than a decade ago. This situation is exacerbated when citizens rush to withdraw their money from the bank in fear of lack of liquidity. And as has been demonstrated over the years, investor behaviour is highly contagious and easy to scare. We have seen this recently with the coronavirus crisis, which has caused panic in the equity markets and its general collapse.
Before the time comes for a mass withdrawal of money from banks, the central bank must step in to prevent a recession and re-encourage money supply through interest rates. In this way, the situation can be turned around. If the private banks feel safe again, they will resume their policy of lending to individuals and companies and the capital will circulate again.
Admirals has extensive educational resources available for you to learn about monetary policies such as quantitative easing, and much more. Click the banner below to create you FREE account and begin your education today!
But, what happens when interest rates are already close to 0% and cannot be lowered further? This is where quantitative easing comes into play.
History of Quantitative Easing
Quantitative easing is a relatively modern concept that was first defined by a German economist based in Japan in the 1990s. Professor Richard Werner understood that the largest supply of money in the economy does not come from the central bank, but from private banks which apply the money multiplier (interest rate) when making their loans. From there, he defended the idea that the central bank did not have to buy so much public debt, but rather aggressively acquire the long-term assets from private banks.
In 2001, the Bank of Japan adopted a new aggressive monetary policy, which it called quantitative easing, but did the opposite of what was suggested by Werner, because it consisted of a massive purchase of public debt. This model proved futile as it did not serve to end a deflationary period of more than a decade, and possibly only led to a second, larger deflationary period.
In 2009, the Bank of England introduced its own version of quantitative easing while also cutting interest rates to enhance the effect. However, this attempt also failed. What the UK did was directly pump money into the economy through private banking, as Werner suggested, but this did not stimulate lending, but just financial trade and the pound, leaving nothing for the British economy, as was intended.
By 2014, the Bank of England had printed some £410 trillion, and although the British economy showed signs of recovery, inflation fell well below the projected 2% level, marking a low of 0.0%, threatening deflation. This was the opposite of what was intended.
At the end of 2008, the US Federal Reserve began its well-known Quantitative Easing plan, which was by far the most ambitious quantitative easing program until the newest plan announced under Trump. Basically, the idea was to buy as many financial assets as possible worldwide. It began with the cheapest assets available, and the numerous mortgage loans that saturated the market because nobody wanted them. These loans included so-called subprime mortgages, which sparked the global financial crisis in 2008.
Source: Federal Reserve Bank of St. Louis. The image shows the historical evolution of the 'Federal funds rate' - the interest rate that banks charge each other when lending money - until March 2020.
The result of this plan was an injection of an additional 3.7 trillion US dollars in the US economy, which spread throughout the world economy over the next five years.
This has been considered by many economists to be the only QE scheme that has been successful, although it has been consistently criticised by non-governmental economic sources. However, this plan only helped to get the economy on the road to recovery, not as an entire cure.
More recently, in 2018, the Fed initiated a policy of gradual increases in interest rates and then re-approved decreases from the beginning of 2019, among other reasons, due to pressure from Donald Trump, who is interested in a cheaper dollar to favor exports in the midst of a trade war.
Fed 2020 - Response to the Coronavirus Crisis
The pandemic that has paralysed economic activity in much of the world, and has led major central banks to coordinate a response to the imminent recession that market participants are expecting. Sunday, March 15, 2020, will be a date for the history books, as the day the Federal Reserve, in coordination with its counterparts in the EU, Switzerland, Japan, Canada and the United Kingdom, announced the largest stimulus package since the financial crisis to minimise the effects of the pandemic.
The new QE comprises the following decisions:
- A drastic reduction in interest rates to a range of 0-0.25% from 1-1.25%.
- The purchase of assets worth 700 billion dollars. In the coming months, the Fed will buy $500 billion in Treasury bonds and $200 billion in mortgage-backed assets.
- The Fed and the other central banks have agreed to reduce the prices of their swap lines in order to facilitate the provision of dollars to financial institutions.
These measures, however, did not have the expected effect on the stock markets, which responded with further falls and remain unbalanced. The US 10-year bond was, once again, a refuge with a slight drop in its profitability.
In the currency market, volatility was the dominant trend. Investors punished the dollar as the euro pointed to gains on the first day after the measures were known. Let's look at this EUR/USD chart:
Source: Admirals MetaTrader 5 Supreme Edition. H1 EUR/USD chart. Data range March 13, 2020 - March 16, 2020. Prepared on March 16, 2020. Please note that past returns do not guarantee future returns.
As we can see in the graph, between the closing of Friday, March 13 and the opening of Monday, March 16, there has been a huge gap and in the subsequent hours high volatility. It will be necessary to wait in the next days and to be very attentive to the development of the events with prudence and patience.
If you want to take advantage of the volatility in the forex market, click the banner below and begin trading with the most sophisticated trading platform in the industry, MetaTrader, completely FREE!
In 2015, the Eurozone embarked on a quantitative easing program of its own in an attempt to inflate the EU economy. The ECB's quantitative easing policy started with a 'modest' trillion dollars - modest compared to the size of its economy.
The idea of the European Central Bank was quite similar to that of the US Federal Reserve, since the QE involved the purchase of financial assets, including the public debt of the member states of the Eurozone, as well as the assets of the agencies and institutions. This plan established an annual inflation rate of 2%, the same as the rest of the countries that applied the QE.
Quantitative easing is not without its critics. On the one hand, some argue that unproductive investment is by nature deflationary. That is why they consider "pouring cash" into private banks as an ineffective method, since they use it instead on the financial markets instead of using it to extend loans to the population, thus being a failed manoeuvre.
On the other hand, another school of financial experts claim that aggressive monetary policies such as quantitative easing pull economies out of their business cycles by smoothing out the recession, so central banks can soften the post-recession economic boom.
The Bank for International Settlements (the central bank of central banks), while remaining impartial and observing national central banks, has warned that the world has become too dependent on economic stimuli, while Germany's central bank has stated that quantitative easing has helped certain economies carry out their financial reforms, such as Italy.
Quantitative Easing - Forex
There are two key reactions in the forex market after the execution of these stimulus policies:
- The instant spike when the news is announced.
- The eventual price adjustment that begins to influence the market after the application of the policy.
So what happens when the QE is announced? What happens when it is applied to the market? In theory, the answer in both cases would be to cause weakness in a currency, since with this policy we add more currency in circulation.
However, the truth is that the announcement of the QE by the ECB caused the EUR/USD to fall 500 pips in the following two days, but from that moment the fall stopped, as we can see in the following chart:
Source: MetaTrader 5. D1 EUR / USD 22 January 2015. Graph prepared in September 2019.
For its part, the United Kingdom announced quantitative easing in March 2009. The GBPUSD fell 600 points in two weeks, but recovered in the following four months remaining in rank for the rest of the year.
Source: MetaTrader 5. W1 GBP / USD March 2009. Chart drawn up in September 2019. The
The US announced the first round of Quantitative Easing in December 2008, and the following week the EUR/USD gained 2,000 pips to finally return to its original level, and for the next month it grew steadily for half a year to once again enter the range.
Source: MetaTrader 5. D1 EUR / USD December 2008. Graph prepared in September 2019.
The dollar lost value throughout this journey until 2011, and has been gradually appreciating since then. For its part, Japan began a new round of quantitative easing in April 2013, causing the currency of the country of the rising sun to depreciate 900 pips against the US dollar.
However, the exchange rate between these currency pairs has stabilised for the following year and a half. In summary, the first reaction is to sink the inflated currency, but over time, it appreciates despite the theoretical logic. So far, statistically speaking, Quantitative Easing has turned out to be deflationary in nature for the Forex market.
If you want to try trading the currency markets in this current time of financial stimulus, all while doing so completely free of risk, open a FREE demo account by clicking the banner below:
Quantitative Easing - Economic growth
There are essentially two types of economies:
In either case, they have to grow at a more or less a constant rate. If an economy stops growing or even if its growth rate slows down, it enters a zone of stagnation or even recession. This is very important so it bears repeating: unless the economy grows at a steady or increasing rate, we will go into recession.
The main difference between developing and developed economies is in the rate of growth. Developed economies, such as the US, the UK, Japan, and Germany, consider a 2% increase in annual GDP as acceptable growth.
In contrast, developing economies such as those of the BRIC countries (Brazil, Russia, India, China) are considered to be in good shape when they grow around 6-8% of GDP annually.
Imagine that you are part of a government in a developing country. What do you need?
A country needs to produce more to meet the growing demand of the population. This can be accomplished in two different ways, by increasing the number of workers, and increasing their efficiency
For example, a single farmer works the land with a plow. Good for them, but the economy could do much better. As a member of the government, you can invest part of the budget to grow agriculture a hundred times, but how? Employing 99 other men with their plows, or by using a tiller to do the work of those 100 men with their plows.
It is important to note that you will have to train the workers to learn how to use the tiller machine.
In this regard, there are a couple of things to keep in mind:
- Production in your growing small economy has increased, but for it to continue to move at a steady rate, you need to keep adding machinery or adding men with plows at an ever-increasing rate.
- Adding workers is usually the main option in developing economies since they have a large number of low-skilled people, this happens in countries such as India or China, for example.
On the other hand, in developed economies such as the US or Germany, which are characterised by low population growth rates and by their high educational and technological levels, they prefer to provide machinery. As you can see, the development of a mature economy in an already developed country goes through constant technological advance, which is the only opportunity to increase production at a desired speed. We will also remember that agricultural land in a developed country is a limited resource, as is its agricultural yield. Therefore, to support the growth of their production power they will need new technological advances, machinery, fertilisers, genetically modified plants, etc.
Developing a financial system
If an economy is growing, the need for money is growing because, in whatever way we can support growth, money is required to start work and improve performance.
This means that the financing of the economy must grow at an ever increasing rate. Now we face a problem: where do we get the money we need for our economy to grow at a faster rate? You can create a banking system with a large national central bank at the helm of a network of smaller privately owned banks. Once the banking system is created, take a piece of paper, insert a watermark, and issue a bill of guarantee of funds.
In this way, money and debt is created simultaneously, and it can be done over and over again. Now, let's forget about debt for a moment and focus on financing economic growth with the newly created money. Congratulations, you have just created a government bond (one unit of national debt). The next step is to organise an auction to which we will invite the banks to buy our bonds. Banks can buy that debt and hold it until you have paid everything off, or they can go to the central bank and exchange the bond for real money.
You can trade the currencies from many of the leading developed or developing countries with Admirals, just click the banner below to open your FREE account!
The money creation trap!
Be careful: the more money that is created, the more money is in circulation, and therefore, the less value it has, as is the principle of supply and demand. The process of increasing the money supply in your economy is what is called inflation.
So if you want the economy to continue to grow, the central bank should continue to print money, but at a rate that is neither too fast nor too slow. Generally, the different economies try to keep inflation at an optimal level for growth. This level is typically between 2% and 5% annually. Deflation is considered to be below the 2% target, which is dangerous because it can slow economic growth and lead to a crisis.
This is an important point to keep in mind, because if there is not enough money in circulation for citizens to pay for the products that the economy produces, companies will be forced to make adjustments, production will decrease, and in the blink of an eye, 30% of the population may be unemployed. Only because the money supply has decreased by a small percentage.
So, low inflation is bad, but what happens when inflation is too high? Any inflation above 7% to 10% is called hyperinflation and this is also very dangerous because it announces another type of crisis. It is the one generated by creating money too quickly: there will come a time when you will have a lot of cash, but you will not be able to buy much because the prices will increase as the money loses value. Hyperinflation in the Weimar Republic in 1921 rendered the paper issued by the Bundesbank so useless that the Germans ended up burning banknotes on their stoves to get through the harsh winter.
Once you have calculated an optimal inflation rate for your economy, you will have to establish a target for your central bank. In other words, if we want annual inflation of 3%, the central bank will have to find the balance to achieve it. To do this, it can resort to several mechanisms:
- Lend money to the government so that it spends it on infrastructure, for example, by building roads.
- Lend money to commercial banks to lend to customers, whether individuals or companies, so that money circulates through them.
The second option is more difficult to control because private banks have their own economic interests, and if they cannot obtain a benefit from this approach, they will not go to the central bank to request loans. In the same way, if the banks do not find clients to whom to lend money and profitable businesses, the method will not compensate them either, which halts the circulation of money.
Faced with this dilemma, what can a central bank do to make financial institutions ask to borrow money? The answer is simple: by modifying interest rates. Lowering interest rates means cheaper loans for banks and, therefore, a greater margin to be able to obtain benefits when they lend it to their clients.
- Low interest rates = More loans = Higher inflation
- High interest rates = Fewer loans = Lower inflation
Hence, private banks are a key player in the currency supply in the economy. If the central bank can add money to the economy, private banks can multiply the money in circulation through a system called 'fractional reserve banking' which consists of banks holding only a fraction of their customer's funds.
Let's take an example to see it more clearly:
- John goes to the bank and opens an account with an initial deposit of €100. Thanks to the fractional reserve system, the bank can now lend €90 of that money, since it only needs to keep 10% in the reserve.
- James wants to take out a €90 loan to pay for a bet he lost to Helen. The bank lends it to him with the money deposited by John.
- Helen collects her friend's debt, and decides to save that money in her bank account, so she deposits €90. The bank now has 90% of that money, €81, to lend to the next customer who needs a loan, Judy.
From the entity's point of view, the accounting notes cover:
- John with €100 in his account
- Helen with €90 in her account
- Judy with €81 in her pocket
In total, €271, but the bank has only handled €100. This is how money is multiplied by private banks through issuing loans.
Quantitative Easing - Banking system
Although the banking system can influence the money supply, only the improvement of economic conditions can increase the demand for it. However, individuals, businesses, and banks will only borrow money if they know they can pay it back. Therefore, only through the creation of a secure and stable economic environment will the government be able to influence the demand for money. A drop in demand means less money in circulation than a growing economy requires.
The end of quantitative easing?
At the end of 2018, the European Central Bank decided to end monetary support for financial institutions in the Eurozone. At the same time, it maintained its policy on low interest rates. The question is whether the timing was right. The economy is showing signs of slowing, with factors aggravating it such as the trade war between the US and China, Brexit, etc. It is precisely this context that has led the ECB to consider new stimulus policies and new rate cuts. But as we have seen with recent measures taken by the US in response to the Covid-19 economic crisis, there may still be a place for quantitative easing for the near future.
Quantitative Easing - Conclusion
The effects of quantitative easing on economies are still being analysed today without reaching a definitive conclusion, since, as we have seen, the reaction has been different in each case.
In most of the countries where any type of QE has been attempted, it has had an impact on inflation, which has sometimes led to deflation. Mature economies have been able to recover their collapsed industries, but the money created has crossed borders, creating large economic bubbles in developing countries.
If you are a beginner or professional trader, you can practice Forex trading strategies without risking your own capital on a FREE demo account with Admirals! Click the banner below to open your account today:
Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.