THE PROBLEM WITH QUANTITATIVE EASING
Quantitative Easing, also known as (QE), is a monetary policy enhanced by the central bank whereby it purchases long-term government bonds and other financial assets from the open market in order to inject more money into the economy to expand economic activity. The main function of such policy is to rapidly increase the money supply and expand economic growth. This policy was introduced by Former Federal Reserve Chairman, Ben Bernanke in 2008 and was first used in March 2009, with the Federal Reserve purchasing $1.25 trillion in mortgage-backed securities, $200 billion in agency debt, and $300 billion in long-term Treasury securities. In response to the economic shutdown caused by COVID-19, in March 2020, the U.S. Federal Reserve announced a quantitative easing plan of over $700 billion. It is important to note that QE is an unconventional monetary policy that is used in situations of economic crises.
1 – Process of the Implementation of Quantitative Easing
The reason why QE is labeled as “unconventional” is because it is different from what the Federal Reserve usually does, which is adjusting the benchmark federal funds rate. Normally, the Federal Reserve would lower its key borrowing rate to stimulate growth and raise interest to stabilize it, and the rate would directly influence short-term rates such as deposit yields and credit card rates.
To implement quantitative easing, central banks increase the money supply by purchasing government bonds and other securities. Increasing the supply of money would lower interest rates, and when these rates are lowered, banks can lend with easier terms. QE is typically implemented when interest rates are nearing zero because, at this point, central banks have fewer options to influence economic growth.
Effect of Quantitative Easing on Money Supply and Interest Rates
According to the Board of Governors of the Federal Reserve System, QE helps improve the financial system in times of severe distress by reducing interest rates in the longer-dated borrowing not directly controlled by the Federal Reserve rate lever, including the cost of taking out a mortgage or an auto loan. By increasing the money supply, QE boosts lending and helps revive the troubled markets by purchasing issued debt, which makes it easier for banks to free up capital, writing more loans, and buying more assets.
Figure 2. Source: Board of Governors of the Federal Reserve System
2 – The Problem of Using Quantitative Easing Excessively
The major problem with the use of QE is that it creates inflation. If we base our reasoning on the quantity theory of money advocated by Milton Friedman, increasing the money supply does increase inflation. The use of QE can increase inflation without necessarily augmenting the growth of the economy, especially in the long-run, which has been the case in the 1970s, with stagflation. In this case, economic output decreases, unemployment increases, and inflation increase as well due to a negative supply shock.
Effect of Quantitative Easing on Inflation
In addition to causing inflation, QE can lead to a depreciating exchanging rate, which will cause the currency to fall over fear of future inflation. During a recession, lowering bond yields is not sufficient to encourage investment trust and banks to take risks with private sector investment. Hence, most investors would prefer the security of a low yield bond than lend to firms, and this is because prospects of a double-dip recession mean the investment is risky. Quantitative Easing may look like fiscal policy, but it is not fiscal policy. If QE failed to be effective in stimulating investment, this then leads to a pro-active role of government to apply fiscal policy to stimulate demand.
According to economist John Brian Taylor, the inventor of the Taylor Rule, quantitative easing creates unpredictability. Since the increase in bank reserve may not immediately increase the money supply if held as excess reserves, the increased reserves create the danger that inflation may eventually result when the reserves are loaned out. Quantitative Easing benefits debtors but harms creditors because there is less money to pay back in addition to devaluating the currency, which will inflate the price of goods.
Lastly, quantitative easing increases income inequality by benefiting those who hold stock more than those holding a majority of their assets in the housing market. This means that quantitative easing does not increase wages but only the price of the stock market. Those at the top rely on their assets whereas those in the middle-class rely on their income, but the problem is that quantitative easing does not increase wages. Therefore, the changes in wages significantly impact the middle-class. If wages are high, inequality is expected to decrease because economic output is also high. If economic output is low, then wages either stagnate or are even reduced while those who rely on their assets are not affected by such changes.
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