What is quantitative easing?
Quantitative easing is one of the more complex and intimidating terms, at least for newbies. Actually the concept is pretty straight forward. In order to understand quantitative easing and how it works, you need to know a bit about the money supply. Basically, in well-managed countries there is a controlled supply of money. The government tightly monitors how much money is available, and as a result money retains its value.
Money Supply Management
In some countries, like Zimbabwe, the government doesn’t manage the money supply well. Instead, the government prints money pretty much endlessly and as a result, the money becomes next to worthless. Zimbabwe is one of those countries that has trillion dollar bills simply because a trillion dollars in the local currency isn’t worth very much.
In the United States, Europe, Japan, and elsewhere, governments maintain tight control on the money supply. They do use some methods, however, such as quantitative easing, to increase the money supply from time to time. By doing so they increase liquidity, encourage inflation (which in moderate amounts is healthy), and encourage lending and business activities. When said governments want to increase the money supply, one of their preferred methods is quantitative easing.
Quantitative Easing Then and Now
So what happens with quantitative easing? A hundred years ago if a country wanted to increase its money supply, it would generally do so through physically printing up money. These days, a lot of money actually doesn’t exist in paper form, but instead exists in digital form. Certain central authorities, such as the Fed, are able to increase the money supply by simply creating digital money. This money can be created and then used to buy assets, such as mortgages. The government ends up with assets and money is injected into the financial system. This pretty much sums up quantitative easing explained.
We hope this quantitative easing definition helps! Admittedly, it is a complex subject and sometimes you’ll need to read a few different explanations before everything sinks in fully. Now that you know what QE is, let’s go over some of the recent history so you can see how it is used. Often, seeing things in practice makes it easier to understand in theory.
Many banks have used quantitative easing. Arguably, the Japanese were the first to use it, having been using QE for many years now in an effort to revive their long stagnant economy. The United States Fed made QE a household term during the Great Recession. Fed quantitative easing is probably the biggest QE measure yet done in history. Most recently, the European Union has been using quantitative easing. This is often referred to as ecb quantitative easing because the European Central Bank (ECB) is handling the QE. This sums up the most recent quantitative easing timeline, but things are sure to develop in the future, so make sure you keep an eye on it.
If you take a close look at the QE timeline, you’ll notice that countries only use quantitative easing when they are in trouble. QE is very much an emergency measure, and to be quite frank, central authorities still aren’t sure what the full effects of QE will be. Central banks use QE for several reasons, as we already talked about. Let’ go into some more details.
To Increase Inflation
First off, QE is very useful for increasing inflation. Healthy levels of inflation are important because they encourage people to spend money, rather than save it. When countries suffer from deflation, people tend to hold onto their money because it will be worth more in the near future. Recently, the EU has been facing pressures of deflation, and thus it resorted to QE in order to turn things around and increase inflation. So far, it appears that quantitative easing in the EU is achieving its goals.
To Encourage Lending
Further, quantitative easing can be very useful for encouraging lending. Simply put, QE injects more money into the system, and when banks have more money they are more likely to lend it. At the same time, since QE tends to increase inflation, financial institutions are encouraged to invest or spend their money before it loses value. This was the primary reason that the American Federal Reserve decided to use quantitative easing.
For Economic Growth
Quantitative easing has emerged as one of the more useful tools for encouraging economic growth, and will remain a popular topic among traders. On a final note, when central authorities end quantitative easing programs, markets often drop. When central banks start QE programs, markets tend to rise. Why? Because inflation encourages people to invest to preserve their wealth. As noted, QE programs tend to encourage inflation, which encourages investors to invest. When central authorities stop QE, currencies strengthen, and thus money looks more attractive. For that reason everyone who is involved in trading should keep an eye on public policies and policy makers who are working with QE programs. Any policy changes can have a big impact on markets, and thus on investors and their portfolios.