Quantitative easing (QE) is a strategy used by central banks to inject money directly into the economy. Unlike standard interest rate cuts, QE involves the central bank creating digital money to buy financial assets, primarily government bonds.
By doing this, they increase the money supply and drive down long-term interest rates, which makes borrowing cheaper for businesses and households. The ultimate goal is to stimulate economic activity during periods of slow growth or crisis, though it can carry risks like inflation if not managed correctly.
When you hear financial journalists discussing central banks, the conversation often turns to quantitative easing (QE). It sounds complicated, but it is effectively a "break glass in case of emergency" tool that has become much more common over the last two decades.
In simple terms, QE is the digital equivalent of printing money. However, instead of putting this cash straight into circulation, central banks use this newly created money to buy investments from banks and other financial institutions. It is a powerful form of monetary policy designed to keep money flowing through the financial system when traditional methods have run out of steam.
How does quantitative easing work?
In practice, QE works through a specific chain reaction designed to move money from the central bank into the economy.
- The central bank creates money: The process begins with the central bank (like the Bank of England or the Federal Reserve) creating new money electronically. This isn't physical cash; it is digital credit added to their own accounts.
- The asset purchase: The central bank uses this new money to launch a large-scale asset purchase program. They go into the open market and buy vast amounts of financial securities, specifically government bonds (and sometimes corporate bonds).
- Increasing the supply: When the central bank buys these bonds from pension funds, banks, or insurance companies, it transfers the new money to them in exchange. This results in a significant money supply increase within the banking system. The financial institutions now have more cash on hand to stimulate the economy.
- Rates fall and lending rises: This is the critical step. When there is a massive buyer in the market (the central bank) buying up bonds, the price of those bonds goes up. When bond prices go up, their "yield" (the interest rate they pay out) goes down. This helps lower interest rates across the wider economy, not just for the government, but for mortgages and business loans, too.
- Boosting the economy: With cheaper loans and more cash in the system, businesses are encouraged to invest, and consumers are encouraged to spend rather than save. This surge in spending is designed to kickstart economic activity, helping the country recover from a recession or stagnation.
When is quantitative easing used?
Quantitative easing is usually reserved for difficult economic situations. Typically, central banks will lower their ‘base rate’ (short-term interest rate) as standard monetary policy to try and stimulate growth. However, there is a limit to the amount they can do this and they can only go to zero or a slight negative.
When interest rates hit rock bottom but the economy is still struggling, quantitative easing is deployed.
Famous examples would be the 2008 Financial Crisis and again during the COVID-19 pandemic. These were both cases of extreme shocks to the global financial system, which required more action than cutting rates. Quantitative easing flooded the system with easily convertible ‘liquid’ assets, to stop the economy from freezing up.
Going the other way: What is quantitative tightening?
Quantitative easing is a temporary process. If growing an economy was as simple as adding more money to the system, banks would surely do it all the time. The biggest risk in doing so is pushing the inflation rate to unsustainable levels, so at some stage banks need to ease off expanding the money supply.
This is where quantitative tightening comes into play. Central banks look to reduce the amount of money in the economy by either selling the bonds they previously bought, or by letting them ‘mature’ (expire) without reinvesting the proceeds.
When the central bank sells these assets back to the market, cash is transferred from the financial sector back to the central bank, where it effectively disappears. This reverses the money supply increase created by QE.
But, why do this? Quantitative tightening is typically used when the economy is overheating and inflation is running too high. By reducing the supply of money and selling bonds, the central bank pushes bond yields up. This contributes to higher interest rates, which cools down economic activity and helps bring inflation back under control.
Important to know: When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment.
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