What is Quantitive Easing? When we first hear the term quantitative easing, it sounds like a physics term unrelated to the finance world. Fortunately, it is not something Albert Einstein thought of but a relatively recent government policy to stimulate the economy. Our post on Quantitative Easing will explain this policy in detail and its impact on the economy and the stock market. What We Will Cover Today What is QE? Examples over the years and how markets were affected. Is QE good or bad?
What is Quantitive Easing? Quantitative Easing is a monetary policy used by Central Banks (the Federal Reserve in the US) worldwide to inject money into the economy. Here are the steps in this unconventional process:
1. Central Banks (CB) purchase bonds from financial institutions or fixed assets for the long term.
First, where is this money coming from? The CB creates these funds on its balance sheet. In other words, they are ‘’printing money”. When they purchase the bonds or other assets from financial institutions, the funds are transferred from the CB to the financial institution (i.e. Wells Fargo).
2. This immediately injects money in the form of credit into the economy
In this example, Wells Fargo now has more money in the form of credit to loan to their clients (individuals or businesses). Their clients will take out loans and reinvest the funds back into the economy. Examples of investments can be property, stocks, renovations, etc. Wells Fargo can also use these funds for themselves to purchase other available assets such as stocks.
3. Long-term interest rates decrease
Why do the rates decrease? Would you rather take a loan at 4 or 5% interest? Banks offer credit at a lower interest rate to motivate clients to take out loans.
4. Price of bonds increase, and their yields decrease
As the price of the bond increases due to the heavy CB purchases, its yield (return) decreases. Bonds become a less attractive investment for other investors.
5. Economy growth
Economic growth happens in various ways. First, individuals and businesses who borrowed reinject the money back into the economy as outlined in step 2. Additionally, investments for higher-return assets such as stocks, ETFs and mutual funds, increase which induces the stock market to post higher gains.
Examples Over the Years and How Markets Were Affected
What is Quantitive Easing? QE is a powerful tool to use during periods of high uncertainty, during a financial crash and to avoid further panic in the markets. Here are some examples where this tool was used. In all cases, short-term interest rates were already close to zero.
Japan (2001-2006)
The first use of QE was observed in Japan. Economic growth stagnated for over a decade, and deflation became serious. Japanese banks benefited from a sevenfold increase in their liquidity, from ¥5 trillion to ¥35 trillion, equivalent to US$300 billion. Economic growth slowly returned until the next recession happened…
The Great Recession (2007-2009)
Next, a similar policy was used in the US, the UK and the Eurozone during this great recession.
The US Federal Reserve underwent three rounds of QE in November 2008, November 2010 and September 2012. Each round resulted in funds allocated monthly to buy certain types of assets. For example, they bought mortgage-backed securities, bank debt and treasury securities. The total amount of assets purchased summed to $4.5 trillion.
The Bank of England underwent a similar process over multiple rounds, but to a lesser extent. July 2012 was the last round of purchases bringing the total to £375 billion, equivalent to approximately US$570 billion.
BREXIT BONUS: Brexit created uncertainty in Britain in 2016. An additional round of QE of £70 billion was injected into the economy.
COVID (2020 – TBD)
To conclude this section, similar responses took place to fight the uncertainties caused by the COVID-19 pandemic. The governments mentioned above injected billions into the economy via Quantitative Easing.
By mid-summer 2020, the US Federal Reserve added US $2 trillion in purchases.
By November 2020, the Bank of England had accumulated another £895 billion in purchases.
In March 2020, the European Central Bank revealed €750 billion in funds allocated to fight the pandemic.
The graph below shows the total assets held by the US Federal Reserve, with severe spikes during the 2007-2009 crisis and the COVID pandemic.
How Were the Markets Affected?
How Were the Markets Affected?
As we are all aware, markets have rebounded since those Quantitative Easing measures. After the Great Depression, major indexes regained their momentum for years. After that horrific first half of March 2020, markets have been posting all-time highs. Were these recoveries a direct effect of QE measures?
It is hard to tell, and the data we have is inconclusive and generated mixed data. In the next section, we will elaborate on the good and the bad of QE. Is QE good or bad? To conclude this article, we would like to weigh in on the effects of QE.
Pros
- Lower interest rate and more access to funds for borrowers.
- Stock markets increase, knowledgeable investors can benefit.
- Economic growth increases, there is more money in the economy.
Cons
- Not everyone has the ability to borrow funds
- Non-investors do not benefit. Once again, the wealthies benefit much more. Those most in need aren’t the ones who benefit the most.
- Record stock prices do not mean that the economy is doing well. Unemployment rates were at very high levels during the pandemic. Simultaneously, the economy was doing better by the month
- Inflation affects some more than others.
To put in perspective, here’s a real-life example: Alex received a fat five-digit bonus because his company made billions in profit during the pandemic.
Mary got a $1 hourly raise on her pay while inflation was 6% in 2021. Her money is worth less than in 2020.
Summary
What is Quantitive Easing? To conclude, Quantitative Easing measures seem to stimulate the economy but create other issues. From an investor’s point of view, stock market growth coincides with QE rounds. Moreover, major governments have opted for this measure over the last decade and may continue to do so during upcoming periods of uncertainty.
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