So what is Quantitative Easing?

When interest rates cannot go any lower, a central bank’s only option is to inject money into the economy directly. This is quantitative easing (QE).

QE involves the central bank creating more money. In years gone by this would have involved the printing of money, however these days it is all done electronically. The additional funds created are then used by the central bank to buy financial assets such as government and corporate bonds from banks.

By swapping securities for cash, the banks increase their own cash reserves. As a result they may decide to to lend more to businesses and individuals, which increases the amount of activity in the economy.

Another benefit of QE is that the increased demand for Government bonds drives up their price which consequently reduces their yields (interest rate). This has the effect of driving down long term interest rates, which is the interest rate at which companies and individuals borrow.

If QE works, credit growth should pick up and businesses should find it easier to get credit which should help to stimulate the economy. 

Does it work?

The US Federal Reserve has already instigated this policy of economic stimulus and the second wave is being widely referred to as “QE2”. As to whether this strategy has been effective is highly contentious as the US economy continues to be sluggish and credit condition remain tight. However, there is a common belief that the situation could have been much worse without QE.

It is difficult to look at history to ascertain the effectiveness of QE as Japan has been the only country to trial such a strategy between 2001 and 2005. On the positive side, Japanese GDP didn’t shrink, however GDP growth was moderate and not sustained after quantitative easing ended.  

Many critics of Japan’s QE strategy argue that they were too slow to act and were uncommitted in their approach. It is also important to distinguish the cultural differences between these two countries. Quantitative easing may not be as effective in a country like Japan with a cultural preference for savings. This compares with countries like the US and UK where borrow-and-spend has been the rule for years.

Only time will tell as to whether QE provides the US, and other countries that plan to implement this strategy, with the stimulus required to bolster their economies. In the meantime it is “full steam ahead” for the US Federal Reserve.