What is quantitative easing
The macroeconomic landscape significantly influences public perceptions and biases regarding market trends. We often hear people discussing the U.S "turning on the money printer" as a bullish argument and if you’re in the crypto space you will have likely seen the meme of Jerome Powell printing money.
However, it is common that people talk about the money printer whilst not understanding how the money printer works, specifically when talking about the phenomena of quantitative easing. the common misconception is that QE = money printer but in this article we will explain why this is not the case.
Quantitative Easing (QE) is a monetary policy where the central bank buys financial assets from the private sector on a large scale. These assets usually include government bonds and, occasionally, bonds from major corporations with a low risk of insolvency.
Quantitative easing vs money printing
In dissecting the differences between Quantitative Easing (QE) and traditional money printing, we encounter a fundamental distinction. QE leads to the creation of central bank reserves, whereas traditional money printing results in the production of physical notes and coins.
This difference is crucial due to the destinations of the newly created money. Notes and coins directly enter consumer circulation, while reserves primarily bolster the financial resources of banking institutions. The initial recipient of this money significantly influences where the most immediate price impacts occur. This dynamic sheds light on the observed surge in asset prices in economies undergoing QE, without a proportional rise in general inflation.
However, the nuances of QE extend further. While QE involves the creation of central bank reserves, it simultaneously extracts something from the economy: bonds. Bonds are not just financial instruments; they often function as money within significant segments of the financial sector.
This leads to the second key difference between QE and traditional money printing. Money printing typically accompanies increased government spending, injecting more money into the economy. In contrast, QE does not inherently mean increased government expenditure. If government spending remains unchanged, QE effectively swaps one form of money-like instrument (reserves) for another (bonds).
Essentially we can understand QE, as removing reserves from the financial crust of the economy, while adding reserves to banks. The result is a reconfiguration of the economy's monetary composition, but the overall effective money supply remains relatively stable. This nuanced understanding is essential in comprehending the intricate workings of QE and its distinction from traditional money printing practices.
Why do governments partake in quantitative easing
The question arises: if Quantitative Easing (QE) doesn't alter the effective money supply, what's its purpose? There are several critical reasons for its implementation:
Firstly, it's vital to recognise that reserves are more liquid than bonds and can be readily converted to cash via the central bank. In times of financial crisis, this liquidity and safety are paramount; government bonds, in contrast, may not always be as reliable for immediate payment.
Secondly, the interest rate on central bank reserves typically falls below that of government bonds. By engaging in QE, central banks effectively reduce the availability of government bonds in the financial system, making them scarcer. In economics, scarcity tends to drive up prices. With bonds, a price increase inversely affects their interest rates, causing them to decrease. Consequently, through QE, central banks gain an additional tool to influence not just short-term debt (through reserve interest rates) but also the interest rates on longer-term government bonds. It's important to note, however, that calling QE "money printing" oversimplifies its mechanism and effects. A more accurate term might be "long-term interest rate monetary policy," though admittedly, this lacks the media-friendly catchiness of "money printing."
Thirdly, there's an anticipated effect central banks hope for: by augmenting the quantity of reserves, they aim to encourage private banks to expand their lending activities, thus increasing the quantity of private bank money. However, this expansion is contingent on people's willingness to borrow, which isn't always a given.
Finally, QE has the effect of making government borrowing cheaper by lowering interest rates. This enables governments to potentially increase their spending. If the central bank and the government coordinate their efforts, QE can resemble money printing more closely, as it adds money to the economy without corresponding extraction. However, this government spending in response to QE is not always a certainty.
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