Why can’t we just print more money to pay our way through a crisis? Well, we can, and we do.
So, what actually is Quantitative Easing and why should you care?
Since the pandemic in 2020, the world’s 4 main central banks (the Bank of England, the Federal Reserve, the European Central Bank and the Bank of Japan) have increased their balance sheet of assets – paid for by creating new money – by 11.3 trillion dollars, a rise of 73%. This process of creating money and buying assets is called Quantitative Easing (QE). Conversely, Quantitative Tightening (QT) sees the central bank sell the bonds on its balance sheet. With such a dramatic increase in QE programmes, it is important to know why central banks do it, what it means for the economy and what the potential implications are.
Central banks want to support growth in the economy by allowing credit to flow around the economy at the right speed. This flow is determined by the nominal interest rate that the central bank sets. A high rate means that borrowing in the economy is expensive and saving is desirable – slowing down growth. A low rate means that borrowing is cheap and saving is undesirable – stimulating growth. This balance of money supply is important because it can support the economy in times of recession and avoid the economy from overheating and inflation spiraling out of control.
However, interest rates were already very low at the beginning of the pandemic and thus, lowering interest rates to the zero lower bound did little to offset the shock of government lockdowns – this is called a liquidity trap. In response, central banks ramped up their QE programmes. This meant creating new money to buy lots of assets such as bonds. This increased demand for bonds leads to reduced interest rates across the economy which, as we saw before, supports growth and encourages borrowing and spending.
Now that we know why central banks implement QE and how it supports the economy, let’s explore the potential implications. One criticism of QE relates to how the macroeconomy can become reliant on easy money over a long stretch of time. Even though it was designed as an unconventional strategy to tackle stubbornly low demand, it was used during the pandemic as an emergency response. This means that central banks across the world now face a tough dilemma: exacerbate inflation with more QE or threaten growth with Quantitative Tightening.
In addition, there has been some debate over whether the policy is as neutral as central banks describe. Since it ramps up asset prices (like housing and stocks), asset owners are most likely to profit. Meanwhile, low-income citizens who own less assets and rely on labor income, now face the economic costs of quantitative tightening and a growth slowdown.
As the golden age of monetary expansion winds to a close, the macroeconomic hangover seems to be setting in. Only time will tell whether central banks can have their infinite-money-cake and eat it.