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What Is Quantitative Easing (QE) and How Does It Work?


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The U.S. economy is a cyclical machine that’s known for peaks and valleys, but when the peaks are too high or the valleys too low, economic hardships set in. 

That’s why we have the Federal Reserve Bank (the Fed). The Fed is the central bank of the United States, meaning it heads up monetary policy across the country. The institution has a core goal of sustainable economic growth, which it works to achieve by using the tools at its disposal to keep inflation and unemployment rates in check. 

One of those tools in the Fed’s toolbox is quantitative easing. You might hear the term thrown around in the aftermath of a serious economic crisis. But what exactly is quantitative easing and what does it mean for you?


What Is Quantitative Easing (QE)?

Quantitative easing (QE) is an unconventional monetary policy central banks use when normal open market operations aren’t enough to maintain economic balance. Under QE plans, central banks make large-scale asset purchases in the open market in an attempt to increase the money supply across the economy. 


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Although some call the process “printing money,” that’s not exactly the case. Instead, central banks typically add longer-term government bonds, corporate bonds, and mortgage-backed securities to their balance sheets under these plans; some, including the Federal Reserve, have included stock purchases. 


How Quantitative Easing Works

Quantitative easing may seem like a complex process, but it’s actually a simple one to follow. Here are the steps:

  1. Central Bank Asset Purchases. The central bank purchases Treasury bonds (or regional equivalents), corporate bonds, mortgage-backed securities, and sometimes stocks. 
  2. Liquidity. With each purchase, the central bank pumps liquidity into the financial system. Specifically, the central bank provides the economy’s leading commercial banks and corporations with cash in exchange for their bonds and securities. 
  3. Interest Rates Fall. Financial institutions have so much extra cash, they’re willing to give loans at lower interest rates. 
  4. Corporations Start Hiring. More money makes its way to corporations that begin increasing production and hiring. This helps increase the employment rate.
  5. Consumers Work, Borrow, and Spend. Because more consumers have jobs and interest rates are low, more people feel confident borrowing money for big-ticket items like cars and homes. Moreover, with more money flooding through the economy, consumers start spending more. 
  6. High Corporate Profitability. Corporate profits climb as consumers spend more, leading to more hiring, production, and spending. 
  7. Investors Invest. Increasing corporate profitability acts as a magnet to investors, who ditch safe havens in favor of the stock market. More investment dollars flowing into stocks leads to more available funding for corporations.  
  8. The Revolving Door Spins. All this positive economic activity leads to more hiring, production, profitability, and ultimately growth in the gross domestic product (GDP)
  9. Consumer Confidence Improves. With the economy booming, consumer confidence is restored. 
  10. Quantitative Tightening. Its mission accomplished, the central bank slowly reduces its holdings on its balance sheet through quantitative tightening. Ideally it does this gradually to curb the risk of excessive inflation without spooking the market. 

When the Fed Uses Quantitative Easing

Quantitative easing is an unconventional approach with varying degrees of success throughout its short history as a tool for central banks, so it’s generally the last resort. 

Central banks like the Federal Reserve typically work to maintain balance with normal open market operations — that’s just economics jargon for “changing the short-term interest rate.”

The Federal Reserve increases the federal funds rate when economic activity is too strong and it fears excessive inflation. It reduces the rate when economic activity stalls and the Fed decides it’s time to spur economic growth. 

But in some cases these efforts fail to spur healthy economic activity. When the Fed reduces its interest rate to or near 0%, further interest rate reductions aren’t likely to have any effect on the economy. That leaves few options other than the more unorthodox approach of QE. 


Examples of Quantitative Easing

The first QE plan was launched by Japan and failed to push economic growth to the country’s inflation target. Although that was just two decades ago, several other central banks around the world have attempted similar measures. 

Japan

The first QE program was launched by the Bank of Japan in 2001. 

The Bank of Japan sought to curb deflation and spur economic growth by purchasing Japanese government bonds, private debt, and stocks. 

Unfortunately, the first QE program was a bust. Instead of spurring economic growth, according to The World Bank, the Japanese GDP fell from $5.5 trillion in 1995 to $4.58 trillion in 2007 in the wake of the program. 

United States

The United States launched QE plans in 2009 and 2020. The former was an attempt to spur economic development following the Great Recession. Some economists credit the multitrillion-dollar QE plan as one of the measures that led to one of the biggest economic expansions and longest-lasting bull markets in the country’s history. 

The QE plan in 2020 was designed to combat the economic fallout of the coronavirus pandemic. However, some experts argue that the Fed was too aggressive and that the easing combined with other factors, primarily rising energy costs, led to dangerous inflation levels. 

Switzerland

Following the Great Recession, the Swiss National Bank unleashed what became the largest QE plan compared to GDP in history. Over the course of several years, the QE program inflated the Swiss National Bank’s balance sheet so much that it owed more debt than the entire country’s GDP. 

The Swiss economy eventually recovered but the plan failed to reach inflation targets, leading to questions surrounding its effectiveness. 

England

In 2016, the Bank of England announced plans to purchase 60 billion pounds of government debt and 10 billion pounds of corporate debt in an effort to relieve fears of an economic collapse following Brexit. 

A crisis was averted in the end, but economic growth following Brexit was slower than the years prior. As a result, many question whether the QE plan was effective. 


Quantitative Easing vs. Quantitative Tightening

Quantitative easing increases the money supply by increasing the liabilities on the Federal Reserve’s balance sheet. The central bank uses this tool as a last resort to spur economic growth when interest rate reductions prove to be inadequate. 

Quantitative tightening is the polar opposite of quantitative easing. 

Once QE has had a positive impact on the economy, the Fed lets assets on its balance sheet mature, slowly removing them and pulling the excess supply of money out of the economy. Quantitative tightening is designed to run silently in the background because being too aggressive could shock the economy. 


Effects of Quantitative Easing 

Quantitative easing is a hotly debated topic among economists, and QE plans have had varying degrees of success. 

The truth is there’s no way to quantify the exact effects of QE programs. That’s because QE generally happens after central banks reduce interest rates to or near zero, which theoretically should improve economic conditions on its own but the effects of which may be delayed. 

Moreover, economies are naturally cyclical. Some economists suggest that the successful QE programs were only successful because the economic cycle was already due for a rebound. 

Regardless of which side of the fence you stand on, there are a few potential negative effects of QE.

Rapid Inflation

Some argue that pumping new money into financial markets is a recipe for excess inflation. Others argue that since the money is funneled through banks and corporations, the process keeps inflation in check. 

If the former is true, improperly managed QE programs can result in prices rising faster than consumers can keep up with them. 

Stagflation

Worse than inflation is stagflation. It’s possible that quantitative easing programs lead to inflation without having the intended economic benefits. 

Although the Federal Reserve can make liquidity available, it has no legal oversight of banks or consumers. It can’t force banks to lend the newly available money to consumers. Neither can it force consumers to take out new loans or spend their money on goods and services. 

QE that fails to kickstart the economy can lead to stagflation, which occurs when inflation heads up while GDP remains flat.

Some fear that the Federal Reserve’s aggressive QE plan following the COVID-19 pandemic may lead to a period of stagflation right here at home. But, once again, there are far more factors at play in today’s economic situation than just QE. 

Excessive Financial Reserves

Critics of quantitative easing argue that much of the money pumped into the economy through QE is never used for its intended purpose — and there’s evidence to support that claim. 

The Fed embarked on a massive QE plan after the 2008 global financial crisis. From 2009 through 2014, the Fed increased its liabilities by nearly $4 trillion. The Federal Reserve’s balance sheet was as large as it had ever been, and all the money from excess holdings was intended to support economic growth. 

As the Fed started the quantitative tightening process in the latter part of the 2010s, financial institutions had a record $2.7 trillion in excess financial assets in reserves. Those numbers suggest that big banks, rather than consumers, were the primary beneficiaries of the Fed’s aggressive QE efforts. 

Income Divide

It’s impossible to ignore the income divide between the average American consumer and the uber-wealthy. In some ways, QE widens the gap between the two. 

The Fed doesn’t have the capacity to lend money directly to consumers; it uses commercial banks as intermediaries. There’s a strong argument that the people hardest hit by tough economic times are those least likely to receive loans from financial institutions. 

As such, some experts argue that QE benefits higher-income Americans who own stocks and qualify for loans, and leaves lower-income Americans out to dry. 

Market Bubbles

QE plans are designed to spur lending, which does improve overall economic conditions, but that lending can also lead to market bubbles with significant consequences when they pop. 

For example, if mortgage rates are at record lows and the economy is booming, more people are going to buy houses. Soon, the housing market will bubble as demand skyrockets but supply grows at a normal rate. 

Such market bubbles can pop once the market loses the widely available liquidity and low interest rates that spawned them, and the results can be felt around the world. 

In 2001, the world learned just how dangerous market bubbles can be when the dot-com bubble popped. The global economy also was rocked in 2007 and 2008 when the U.S. real estate bubble took on more hot air than it could handle.  


Quantitative Easing FAQs

Quantitative easing is a topic of debate among economists. Because of its inconsistent record of success in the past, even the experts have questions that haven’t yet been fully answered. So don’t be ashamed if you have a few questions of your own about QE. 

What Does Quantitative Easing Mean for Consumers?

Quantitative easing typically means a few things for consumers:

  • Loans Are Easier to Come By. One of the biggest effects of QE for consumers is easier access to loans. QE results in a flood of money making its way to the economy’s leading financial institutions. Those institutions are more inclined to lend money when they have more of it in reserves. 
  • More Jobs. If a QE plan has its intended effect, it will spur economic growth, leading to improving employment numbers. If all goes well, you end up with more options when you go on the job hunt. 
  • It’s Time to Invest. Quantitative easing has the potential to cause inflation, and one of the best ways to combat inflation and protect your wealth is by investing. The best part is that markets are typically booming when QE plans are in effect. 

How Does Quantitative Easing Affect Bond Yields?

Quantitative easing reduces returns on long-term bonds because the Fed significantly increases the demand for them. With increased demand, issuers don’t have to pay high interest rates to sell their bonds and access the funding they’re looking for. 

How Long Does Quantitative Easing Last?

QE is a relatively new tool in central banks’ toolboxes — one that hasn’t been used very much in the couple of decades it’s been around, so there’s no set period of time that most plans last. 

Even in the United States, the two times the Fed has used QE had very different time frames. 

The first time the Fed used a QE plan was in 2009. The Fed continued to add assets to its balance sheet through 2014 and didn’t begin the tightening process until 2017. 

In 2020, the Federal Reserve announced a new QE plan, purchasing hundreds of billions of dollars worth of assets over a very short period of time. Just two years later, the central bank began the quantitative tightening process. 

Ultimately, the time frame for QE is however long it takes for the economy to begin moving in a positive direction. 

What Happens When Quantitative Easing Ends?

The end of quantitative easing, known as quantitative tightening, isn’t supposed to have any effect on the economy. However, it often can have unintentional effects. 

When QE ends and QT begins, interest rates are likely on the rise, starving the market of liquidity — spendable money. This could put pressure on the stock market, lead to increased unemployment rates, and potentially slow GDP growth. 


Final Word

Quantitative easing is a controversial monetary policy, but the concept makes sense. When economies are struggling, central banks use these plans to pump excess cash into the market with hopes of that cash trickling down to the end consumer and spurring positive economic activity. 

Although the process has worked in the United States — possibly too well in the 2020 QE plan — it has failed in other regions at other times, leading to questions about its validity. 

Nonetheless, when central banks have their backs against the ropes and have exhausted their usual playbook, QE is one tool they use in an attempt to kickstart positive economic developments. 

Joshua Rodriguez has worked in the finance and investing industry for more than a decade. In 2012, he decided he was ready to break free from the 9 to 5 rat race. By 2013, he became his own boss and hasn’t looked back since. Today, Joshua enjoys sharing his experience and expertise with up and comers to help enrich the financial lives of the masses rather than fuel the ongoing economic divide. When he’s not writing, helping up and comers in the freelance industry, and making his own investments and wise financial decisions, Joshua enjoys spending time with his wife, son, daughter, and eight large breed dogs. See what Joshua is up to by following his Twitter or contact him through his website, CNA Finance.

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