Definition of quantitative easing

Central banks normally set the price of money using official interest rates to regulate the economy. These interest rates radiate out to the rest of the economy. They affect the cost of loans paid by companies, the cost of mortgages for households and the return on saving money. Higher interest rates make borrowing less attractive because taking out a loan becomes more expensive. They also make saving more attractive, demand and spending reduces. Lower interest rates have the reverse effect.

But interest rates cannot be cut below zero and when official rates get close to zero the effect they have on regulating the economy becomes muted. Banks still need to make a profit and in troubled times the gap between the official interest rate and the rates faced by companies and households can rise, because lenders want a greater return for the additional risk of granting a loan when times are tough.

When interest rates are close to zero there is another way of affecting the price of money: Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and households and the most important step in QE is that the central bank creates new money for use in an economy.

Only a central bank can do this because its money is accepted as payment by everybody.  Sometimes dubbed incorrectly "printing money" a central bank simply creates new money at the stroke of a computer key, in effect increasing the credit in its own bank account.

It can then use this new money to buy whatever assets it likes: government bonds, equities, houses, corporate bonds or other assets from banks. With the central bank weighing in, the price of the assets it buys should rise and the yield, or interest rate, on that asset will fall. Companies for example with a willing central bank seeking to buy its bond, will be able to pay a lower interest rate when new bonds are issued or existing bonds come to the end of their life and need to be replaced.

With cheaper borrowing the hope is that the central bank will again encourage greater spending, putting additional demand into the economy and pulling it out of recession. As the money ends up in bank deposits, banks should also find their funding position improved and make them more willing to lend.

A side effect will be that this new money is expected to raise consumer prices giving people another incentive to buy now rather than later.

Of course there are risks. First, a central bank can lose money on its purchases, money that will ultimately have to be underwritten by taxpayers either with higher future taxation or by the central bank creating more money and risking higher future inflation. Second, go too far with creating and spending money and you will destroy the value of the currency. Inflation or even hyperinflation is the result. Third, if a descent into QE destroys confidence in an economy rather than gives reassurance that the authorities are on the case it can be counter-productive.

That is why central banks cannot use QE willy-nilly, but if you are not aggressive enough QE simply will not work to change other interest rates in the economy and stimulate demand. The trouble is, because the policy is unorthodox and the situation is dramatic no one knows how much QE is too much and how much is not enough. Who would be a central banker at the moment? [1]

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