Why Central Banks Use Quantitative Easing - and What It Does

Why a Central Bank Turns to QE

• The policy rate hits its floor: Once the short-term target is near zero, further conventional cuts are unavailable, so the central bank works on longer maturities instead.
• Deflation risk: Falling prices raise the real burden of debt and encourage households to postpone purchases, a dynamic that is hard to escape once it starts.
• Dysfunctional markets: When trading in core markets such as Treasuries or mortgage-backed securities breaks down, large purchases can restore the ability to transact.
• Impaired credit channels: If banks and securitisation markets are not passing lower rates through to borrowers, buying assets directly can bypass the blockage.
• A need to signal: Committing to a large purchase programme communicates that policy will stay accommodative for a long time.

How QE Is Supposed to Work

• The portfolio balance channel: By removing long-duration securities from private hands, the central bank pushes investors into other assets, bidding up their prices and pushing down yields.
• The duration channel: Buying long-dated bonds reduces the amount of interest rate risk the market must hold, which compresses the term premium.
• The signalling channel: A large purchase programme reinforces guidance that the policy rate will stay low, lowering expected future short rates.
• The liquidity channel: A standing buyer restores confidence that securities can be sold, narrowing bid-ask spreads in stressed markets.
• The exchange rate channel: Lower domestic yields tend to reduce capital inflows, which can weaken the currency and support exports.

Observed Effects

• Lower long-term yields: Most empirical studies of the announcements find measurable declines in Treasury and mortgage yields around them, though estimates of the size vary widely.
• Higher asset prices: Equity and property valuations tend to rise as discount rates fall and investors move into riskier assets.
• A much larger central bank balance sheet: The Fed's holdings grew from under one trillion dollars before 2008 to roughly four and a half trillion by 2014 and to about nine trillion by 2022.
• Abundant bank reserves: Purchases are settled by crediting reserve accounts, which changed how the Fed steers rates and led it to rely on interest paid on reserve balances.
• Restored market functioning: The clearest and least disputed effect, visible in March 2020, was ending a liquidity spiral in the Treasury market.

The Main Criticisms

• Distributional consequences: Because QE works partly by raising asset prices, its immediate benefits accrue most to those who already own assets.
• Risk-taking incentives: Suppressing yields pushes investors toward riskier holdings, which can build financial vulnerabilities over time.
• Uncertain potency: Estimates of QE's effect on output and inflation are much less precise than for conventional rate changes, and diminishing returns are widely suspected.
• Blurred boundaries: Large-scale purchases of government debt raise questions about the line between monetary policy and fiscal financing.
• Exit difficulty: Unwinding a large balance sheet without disturbing funding markets proved harder than expected, as the money-market strains of September 2019 demonstrated.

What QE Is Not

Quantitative easing is frequently described as printing money, and the shorthand obscures more than it explains. The central bank does not create physical currency to buy bonds; it credits the reserve account of the selling institution, swapping one financial asset for another on private balance sheets. Broad measures of money in the hands of households and firms rise only if that reserve creation leads to additional bank lending or if the securities are bought from non-banks whose deposits then increase. This is why the large expansions of the Fed's balance sheet after 2008 coincided with inflation running below the two percent objective for most of the following decade — an outcome that surprised many critics at the time and that remains an important piece of evidence about the limits of the tool.