One of the main tools to increase rate of growth in a country is to lower interest rates which encourage people or companies to spend money, thereby increasing the effective demand and hence profitability. However, there is a limit to this strategy; when interest rates are at almost zero, you are left with no option. In that case central bank starts pumping money directly into the financial system. This process is known as Quantitative Easing, or QE.
How Quantitative Easing works?
Process is fairly simple and straight forward. The central bank creates money electronically and buys bonds either from the government or from financial institutions investors such as banks or pension funds. This increases the overall amount of useable funds in the financial system, making more money available to encourage financial institutions to lend more to businesses and individuals. This in turn should allow businesses to invest and consumers to spend more, kick-starting the economy.
Which countries have used Quantitative Easing?
QE was first attempted by Japan following its financial turmoil in the 1990s. Results are mixed regarding its effectiveness to arrest the deflation. After the 2008 financial crises, both UK and USA embarked on QE and between 2008 and 2015, the US Federal Reserve in total bought bonds worth more than $3.7 trillion.
On the other hand, the UK created £375bn ($550bn) of new money in its QE programme between 2009 and 2012. Then in August 2016, the Bank of England announced its intention of buy GBP 60 billion worth of government bonds and GBP 10 billion worth of corporate bonds to allay the fears of the markets regarding the likely impact of Brexit.
The Eurozone began has so far pumped in $600bn of extra money since January 2015 in its QE programme.
What are the risks/issues in Quantitative Easing?
Although QE has not been a complete failure if not a resounding success, there are three problems with this approach
- Financial institutions may not be able to lend that additional money to the investors who base their investment decisions on the basis of several considerations; rate of interest being one of them.
- They borrow the money but do not use it for new investment; rather utilise it in buying the property which could create the feared property/assets bubble
- When inflation is close to zero, a bit more upward pressure on prices can be seen as a good thing. It may ultimately lead to inflationary pressures at a later stage which cannot be controlled without stagflation-worse than a mere deflation.
- QE pushes up the market price of government bonds and reduces the yield, or interest rate, paid out to investors. In other words, investors have to pay more to get the same income.
- Lower market interest rates depress the value of a currency because it becomes less attractive to foreign investors. The US’s programme of QE also kept the value of the dollar lower than it might otherwise have been, a factor not welcomed in some emerging economies.