Quantitative Easing: two fairly big words that say very little about what the concept actually means, I think.
Simply put, QE happens when a government prints and pumps new money into the money supply through its central bank in an economic downturn.
Similar to—and usually an extension of—expansionary monetary policy (where the central bank buys short-term government bonds in order to lower short-term market interest rates), QE involves the central bank buying financial assets from commercial banks and other private institutions to increase money supply.
Central banks usually resort to QE when interest rates are already as low as 0%, and conventional expansionary monetary policy is no longer effective in helping the economy.
Since it cannot do any more to lower the interest rates by buying short-term government bonds, the central bank then tries to stimulate the economy by buying assets of longer maturity.
This lowers longer-term interest rates while increasing the prices of the financial assets bought (lowering their yield).
QE can also be used to fight deflation by raising prices.
The thing is, inflation is a natural consequence of QE.
As the money supply is increased to promote lending and liquidity, prices also rise. This is because there is still a fixed amount of goods for sale despite the increase of money in the market.
Still don’t get it? Don’t worry, you’re not the only one!
Let’s use the Smurfs as examples.
Let’s say there’s a recession in Smurfland one day. Unemployment is at its highest and smurfs are defaulting on their home loans in record numbers and thus risk being kicked out of their mushroom houses.
The Smurf Central Bank (probably controlled by Papa Smurf) is holding $700 million worth of Smurf Treasury (or Smurfury) notes at the time.
Papa Smurf makes a decision for the Smurf Central Bank to buy Smurf securities (or Smurfcurities) since the Smurf interest (or Smurfterest) rate at the time was already close to 0%. Over the next few years, the Smurf Central Bank bought $2.1 billion worth of bank debt, mortgage-backed Smurfcurities and Smurfury notes.
The Smurfconomy (Smurf economy) starts to improve slightly, but because opportunists like Greedy Smurf and Speculative Smurf have given Smurf housing loans to too many smurfs who could not afford them, those poor smurfs are starting to default on their housing loan repayments.
In an effort to simply sustain the Smurfconomy, the Smurf Central Bank continues buying Smurf bonds and mortgage-backed Smurfcurities every month. This keeps Smurfterest rates at near zero, and unemployment can then begin improving.
However, since there is now so much more Smurf money in the market even though the production of Smurf goods remains the same, prices in Smurfland also rise.
Now Papa Smurf thinks it’s time for the Smurf Central Bank to ease off its Quantitative Easing measures. It will start buying $40 million instead of $85 million worth of Smurf assets a month.
The problem in this scenario that seems to work out for almost everyone is that the Smurf stock markets aren’t too happy to hear that at all.