Economists tend to have a way of applying confusing terms to important actions made by governments and central banks which can definitely cause confusion among those who are not familiar with the science.
The coined term: Quantitative easing is a perfect example of this.
By definition, quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
The whole process seems a bit confusing, but remember that the main goal is to increase the amount of money that is flowing throughout an economy. Why would a central bank want to do this you may ask? Well, more spending means more economic growth. All levels of the economy benefit from more spending; from small businesses all the way up to large corporations and banks – spending helps all business and alleviates unemployment pressures.
The process of quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Quantitative easing is considered when short-term interest rates are at or approaching zero, and does not involve the printing of new banknotes.
Central banks are responsible for keeping inflation in check. Before the financial crisis of 2008-09 they managed that by adjusting the interest rate at which banks borrow overnight. If firms were growing nervous about the future and scaling back on investment, the central bank would reduce the overnight rate. That would reduce banks’ funding costs and encourage them to make more loans, keeping the economy from falling into recession.
By contrast, if credit and spending were getting out of hand and inflation was rising then the central bank would raise the interest rate. When the crisis struck, big central banks like the Fed and the Bank of England slashed their overnight interest-rates to boost the economy. But even cutting the rate as far as it could go, to almost zero, failed to spark a recovery. Central banks, therefore, began experimenting with other tools to encourage banks to pump money into the economy. One of them was QE.
In quantitative easing, central banks target the supply of money by buying or selling government bonds and securities. When the economy stalls and the central bank wants to encourage economic growth, it buys government bonds.
A government bond is a debt security issued by a government to support government spending. Federal government bonds in the United States include savings bonds, Treasury bonds and Treasury inflation-protected securities (TIPS). Before investing in government bonds, investors need to assess several risks associated with the country, such as country risk, political risk, inflation risk and interest rate risk, although the government usually has low credit risk.
Because most government bonds are backed by the credit of the U.S. government, default is unlikely and government bonds are considered essentially risk-free. Thus, government bonds create a benchmark against which riskier securities may be compared.
This process effectively lowers short-term interest rates and increases the money supply. This strategy loses effectiveness when interest rates approach zero, at which point banks have to implement other strategies to kick-start the economy. One of which is the targeting of commercial banks and private sector assets in an attempt to spur economic growth by encouraging banks to lend money.
