The Mechanics Behind Quantitative Easing

Quantitative easing, QE, is the process where a central bank purchases domestic government bonds from financial institutions in order to lower short-term interest rates and increase the money supply. As simple as that. It’s important to understand the mechanics of this policy tool and the real implications on markets, so we will get into the complexities later in this report.

MMH Pro members you should already be familiar with the ideology behind OMO (Open Market Operations) from my previous two reports. For the rest of you, here’s a simple breakdown of what OMO is, open market operations is the process of a central bank buying and selling government bonds to influence the money supply. The greater the money supply the lower the interest rate since there’s more money in circulation within the economy, the opposite is true for tighter (lower) money supply.

Now QE works as an open market operation, the way QE differs from OMO is its sheer size of asset purchase.

The Federal Reserve first launched its QE program on the 25th of November 2008 during the GFC. Whenever the central bank considers QE its usually because interest rates are close to or at the ZLB (zero lower bound) but the growth outlook still remains weak, so QE is the last resort to spark the economy back into action, hence why both QE & QT are considered unconventional monetary policy tools.

Why QE differs from money printing

Alright. We’ve all heard the arguments that QE is money printing and that it’s the cause of this out-of-control inflation story. Well, that’s not entirely true, at least for the most part. Understand this, the effect of QE is to increase the money supply by adding reserves to the banking system, which encourages credit creation (loans). Take note, reserves are money for banks, bank reserves never enter the real economy. So during the process of QE, there is no real form of money (money that me and you can spend) being created.

Silvano Tenreyro, a Member of the BOE MPC (Until July ‘23) had this to say about quantitative easing:

“At a high level, QE aims to affect interest rates using central bank purchases of government bonds, or debt, held by the private sector, financed by issuing central-bank reserves.”

“QE is an asset swap: it does not create new private-sector assets, which is how some may understand ‘money printing’ descriptions. Nor does it involve spending money in the sense that fiscal policy does” —Silvana Tenreyro, BoE, Ex-MCP member

The difference?

Money printing is what the Trump administration and Congress did in 2020.

Trump signing the CARES Act stimulus package
Trump signing the CARES Act stimulus package

The image is of Trump signing the CARES Act, as a brief reminder this act was a $2.1 trillion stimulus bill in response to Covid-19. The bill included direct payments to individuals of $1,100 per adult, small business loans, unemployment benefits and mortgage forbearance (allowed homeowners to defer payments for 12 months).

That ladies and gentleman, is money printing, money being created out of nowhere and injected straight into the economy, increasing the discretionary income available to the average citizen.

One tool creates reserves for the banking system, the other creates actual money and credit resulting in more money chasing few goods.
Let’s take a visual look at what happens to the composition of a central and commercial bank’s balance sheet after QE.

Stylised central bank/bank balance sheet after QE
Stylised central bank/bank balance sheet after QE

The reason I wanted to show you the composition of the central bank balance sheet before and after QE is to emphasise the fact that there is no credit, or money, being magically printed and pumped into the economy, but rather an exchange of government bonds for central bank reserves which the central bank can create.
So simplified:

  • QE directly pushes interest rates lower
  • Removes government bonds from the market
  • Encourages bank lending to the public
  • Provides liquidity to the financial system stimulating the economy
QE Trasmission, source: BoE
QE Trasmission, source: BoE

Here’s a great flow chart of how QE and monetary policy decisions affect the wider economy.

QE’s Effectiveness and Impact on Yields

Now that we’ve got the understanding of QE down to a tee, let’s look at real examples of how QE causes borrowing costs to be cheaper.
GFC 2008 marked the first time the Fed engaged in QE, we all know the story of how the recession happened so I won’t waste your time, let’s look at borrowing costs, yields and the overall effect on markets. This first market intervention was known as QE1.

Effect of LSAP on Interest Rates, Source: FRBSF Economic Letter
Effect of LSAP on Interest Rates, Source: FRBSF Economic Letter

LSAP is an abbreviation for large-scale asset purchase. You can see that the Fed’s first QE program lowered yields on the US10Y yield by 1.00%, corporate yields by 0.89% and reduced the yield on 30y mortgages by 0.93%. This goes to show the depth and success this policy tool can have on financial conditions and borrowing costs; there’s one thing you may have already noticed however.

As the Fed continued to run its QE after the recession in ‘08, you can clearly see that QE had less of an effect on borrowing costs across all three interest rates. Now there’s one obvious reason for this. The first is the size of each QE program.

During QE1, the Fed purchased $ 1.25 trillion of MBS and a further $300b in longer-term Treasury securities, so it goes without saying that the larger the asset purchase program the bigger the effect has on lowering borrowing costs. The second is not so obvious so here’s an insight.

Move index
Move index

I’ve annotated each of the three different QE programs at the bottom of the chart. The reason why the successive QE programs didn’t lower yields like the first QE program is because of how high bond volatility was during the ‘08 crisis. It was the housing, mainly subprime, market that was under extreme heat during ‘08 so when the Fed initiated QE the result had a more dramatic effect simply because the market was in a period of increased fear and uncertainty, so the QE program brought stability back to markets.

The following QE programs were not in the middle of a bond market frenzy hence the reason why yields across mortgage, corporate and treasury bonds were reduced by a smaller amount.

Even though the subsequent QE programs didn’t have as much of an impact on borrowing costs/yields, the Fed’s goal, to loosen financial conditions still materialised within the economy. Mortgage rates declined steadily, encouraging citizens to buy homes, and corporate credit became cheap allowing companies to expand employment and invest accordingly.That brings us to the end of this report.

  • From this, I hope you’ve been able to understand:
  • What QE is in its simplest form
  • How QE differs from money printing
  • The composition of the central bank’s balance sheet post-QE
  • The effect QE has on yields.

I used to and still read reports from industry veterans I follow countless times to really get it engraved in my head. So stay at it, keep grafting and I hope to talk with you soon.

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