Quantitive Easing is a monetary policy action used by central banks to purchase various financial assets from financial institutions in amounts that are pre-determined before the purchase to ensure that only an exact quantity is injected into the economy.
What Does QE Do For Financial Institutions?
QE provides banks with new capital while removing illiquid or generally undesirable assets from their balance sheets. Financial institutions are left with excess cash reserves which are beneficial for two reasons:
- With more cash in hand, firms can lend and invest more while remaining properly capitalized and thus better protected from insolvency risk.
- The central bank purchases balance sheet liabilities, which helps lower a firm’s debt and credit risk, making them more attractive for investment.
What Does QE Do For The Central Bank?
This type of stimulus usually requires that new money be created so that the central bank can make the purchases it plans. Because new money is created and added to the existing supply, inflation increases. The national debt also increases, because the assets purchased by the central bank are usually illiquid short-term investment products (assets with maturities of less than one year) which add liabilities to the central bank’s balance sheet.
Why Do QE?
When a central bank has already used open market operations to lower interest rates to near-zero levels but economic productivity doesn’t increase, it resorts to directly capitalizing firms with new money so that the recipients can increase lending and investment. The central bank gambles that raising inflation and increasing the government’s debt load will generate enough long-term economic growth that future tax reciepts (the government’s primary revenue stream) will offset the short-term risks of buying “toxic” assets from banks.
Anything Else We Should Know?
Quantitative Easing is one of the last things that a central bank wants to do, considering that a central bank’s primary function is to keep inflation at a relatively stable level. QE intentionally raises inflation in the hope that the financial firms that receive the funds will invest them into the general economy at a rate that will produce siginificant increases in economic activity. In this lies the danger, because a central bank (usually) cannot compel private banks to lend or to invest, and thus must trust private firms to actually put the additional capital to use. If they don’t, the central bank essentially raises inflation to take on excessive amounts of risk which will remain until it can sell the assets back on the market. Such a problem is best evidenced in the United States, where the Federal Reserve System has issued hundreds of billions of dollars to the nation’s major commercial and investment banks while seeing only modest reductions in unemployment and tepid economic growth.