Quantitative Easing

Imagine a drought has left your fields bone dry. You turn the faucet as far as it goes, but only a trickle comes out, and then it stops. Normally, when the economy slows down, the central bank opens up a faucet called the benchmark interest rate to increase the flow of money. When borrowing gets cheaper, factories start running and people spend more, so the market comes back to life.

But when a huge crisis hits, even a benchmark rate cut to nearly 0% may not get people to spend or borrow much. Banks lock down their lending for fear of losing their money, and people close their wallets because they are anxious about the future. Rates have already hit bottom, so you can't turn the faucet any further to lower them.

Quantitative easing is the emergency measure used when the normal channels for money are completely clogged. Instead of staring at a faucet that no longer works, you haul in a giant pump and pour money straight into the market.

When people hear "quantitative easing," they often picture a central bank running printing presses day and night and scattering paper bills from the sky. In reality, it doesn't work by printing piles of physical cash and handing it out.

Instead, the central bank creates electronic money on its computer ledger. Then it buys government bonds and other safe financial assets that banks and investors hold, on a massive scale. A government bond is a kind of IOU, a promise by the state to pay back later. The people who sell the bonds see huge sums newly credited to their accounts.

When the central bank buys bonds in bulk, bond prices rise and long-term interest rates fall. The sellers then use the money they received to buy other assets, such as corporate bonds and stocks, which makes it easier for companies to raise money. The hope is that the huge amount of money the central bank supplies will spread through the economy by way of interest rates and asset markets. How much bank lending actually rose differs from study to study.

Quantitative easing is an emergency measure that pumps a huge amount of fuel straight into a stalled economic engine to restart it. Many people credit it with playing a big role in preventing a chain reaction of collapse around the world when massive shocks hit, such as the 2008 global financial crisis and the 2020 pandemic.

But pouring in money on this scale brings serious side effects too. When money becomes too plentiful, its value can fall and prices can shoot up. The flood of money can also pile into real estate and the stock market and inflate asset bubbles. The gap between people who own assets and people who don't can widen as well.

So once the crisis passes and the economy is back on a normal track, the money that was released has to be gradually drawn back in. After tapering, which means slowly reducing the amount of support, the central bank moves on to quantitative tightening, which pulls money back out of the market.