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Monetary Policy: What is Quantitative Easing and How is it Applied?

Monetary Policy: What is Quantitative Easing and How is it Applied?
Quantitative Easing occurs when the Central Bank of a country purchases securities in order to increase the money supply.
Jun 27, 2016 By Ben Khouri Tags: Education, Quantitative Easing, Monetary Policy, Central Banks

Since the onset of the GFC, a greater emphasis has been placed on central banks around the world to stimulate a recovering global economy. While we don’t want to place excessive emphasis on the actions of central banks, investors should be aware of their purpose and available tools to influence monetary policy.

We now live in an age where, as Mario Draghi, the President of the European Central Bank (“ECB”) famously put it, central banks are willing to do “whatever it takes” to stimulate the global economic environment. The success and measure of Central Banks are debatable and their actions have posed a series of questions: How can interest rates be at, or below zero? How can the central banks adopt such a stance to monetary policy?

One such strategy is commonly referred to as “quantitative easing”. In this piece, we will attempt to explain the unconventional economic phenomenon that is quantitative easing. 

Fundamentals of Monetary Policy

In order to understand quantitative easing, we must first understand the inner workings of monetary policy. Monetary policy is used by a nation’s central bank, where through their influence over the level of interest rates and the money supply (being the sole printers of a nation’s currency), they aim to create a stable financial environment. Most central banks believe that this can be achieved through economic growth, inflation and low unemployment.

Put simply, monetary policy is a tool utilized by a nation’s central bank, in order to achieve a set of economic goals. Like most central banks, the RBA (Reserve Bank of Australia) was born out of government legislation. In turn, it also acts as the government’s bank, where it takes on the role of conducting the government’s day-to-day transactions. Transactions that are necessary for the efficient operation of government.

 

Monetary Policy

Image: Monetary policy is a tool utilized by a nation’s central bank, in order to achieve a set of economic goals.

As mentioned previously, one of the main roles of a central bank is to conduct monetary policy in order to achieve a stabilized level of output, inflation and maximum employment. The central bank has limited tools available and aims to achieve these goals through for example influencing interest rates or money supply within a given economy.

‘Open Market Operations’ is a process, which involves the central bank playing an active role within the market, through the buying and selling of financial assets (for example Government Bonds) from financial institutions (such as Commercial Banks).

Open market operations enable the central bank to influence the availability of credit, through having an influence on the money supply in the economy. For example, if the central bank decides to lower the interest rates, they would increase their purchases of government bonds from financial institutions (such as Commercial Banks) to increase the money supply in the market. Hence, the series of transactions between the central bank and the financial institutions within the economy will have flow on effects, in the form of an increased money supply and a greater availability of credit. The opposite would apply if the central bank sought to increase interest rates to avoid hyperinflation or slow down expansion.

In Australia, the Reserve Bank of Australia (‘RBA’) is currently adopting an expansionary stance to monetary policy, recently cutting the cash rate to a record low of 1.75% in May.

What is Quantitative Easing?

Since the GFC, central banks around the world have been aggressively lowering interest rates in order to stimulate a dampening economic environment. The modern beliefs of today’s Central Banks is that the economy can be stimulated if money is “cheap” and therefore easily available. If consumers and businesses have to pay less to borrow more money, they will likely spend it on the economy, thus increase supply and demand. However, how can a central bank further stimulate an economy when interest rates are almost at zero? One critically debated strategy is called ‘Quantitative Easing’ (or QE). 

Quantitative Easing occurs when the Central Bank of a country purchases securities in order to increase the money supply. The Central Bank essentially “creates” or “prints” new money, which is used to buy financial assets from other commercial banks. The process involves a much more active policy in buying government bonds and other such assorted securities, from a vast range of financial institutions. The idea behind this process is that the banks have now more money available, which can be issued to borrowers such as consumers or businesses. As loans become more easily available, borrowers will lend more money and spend it, thus stimulate the economy.

QE is essentially just another form of OMO. However, the difference lies is the size and scale of the program. Rather than focusing just on short-term interest rates, QE also targets long-term rates. Furthermore, the central bank is concerned to influence the total amount of reserves, thus a significant expansion of their balance sheet is required.

Quantitative Easing around the World

Since the onset of the GFC, we have seen several instances of Quantitative Easing being implemented from central banks around the world. In the USA, we saw the US Federal Funds Rate drop to a record low of 0.25% in 2009. The Fed’s asset purchasing program quadrupled their balance sheet and injected an enormous amount of money in the economy.  Similarly in Europe, we currently see rates at zero. However, one of the most peculiar of cases is in Japan, where rates have gone negative at -0.10%.

Alternative Policies to QE

There have been scholarly discussions with regards to alternative policies to QE. The most prominent being the policy known as ‘Helicopter Money’. Proposed by well-known economist Milton Friedman, this involves the central banks applying an abnormal form of monetary stimulus, whereupon they directly transfer free funds into the private sector’s bank accounts. There are numerous critics who think that the actions of the central banks around the world have gone too far with their programmes, with further discussions of ‘Helicopter Money’ further exacerbating the criticism.

Whilst there are both benefits and disadvantages to such programmes, there is one thing for sure, and that is we are living in an abnormal age of monetary policy, where central banks are pushing their roles to the limit beyond recognition and understanding.

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Fiscal Policy: What is it and How is it Relevant to Investors?

Since the times of the great depression in the 1930’s, fiscal policy has been utilised as yet another tool to influence the level of economic activity within a given nation.

Author: Ben Khouri Jun 29, 2016

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