The rapidly evolving economic and health crisis caused by the coronavirus pandemic has forced the regulators to use an incentive program. The method was adopted by the ECB as a reserve system. These measures are aimed at strengthening the euro's position in the world. In this article, you will discover quantitative easing is, what it consists of, and what are the possible consequences.
What is Quantitative Easing?
Quantitative easing (QE) is a monetary policy following which the central bank begins to buy back bonds in the declared volume to decrease their yield and raise the amount of money in the financial system. Launching QE, the central bank buys out long-term financial assets to infuse a particular amount of funds into the economy. Although usually, not in crisis times, the regulator buys and sells short-term assets, for example, government bonds.
Quantitative Easing in Times of Economic Crisis
This stimulating method is used in states where the interest rate of the central bank has dropped to a critically low level (0%), which does not otherwise extend the money supply in the state economy, thus decreasing the national currency rate. The background of this situation - a crisis of overproduction of goods with high cost, but with a minimum need - the so-called liquidity trap, usually occurs with deflation or very low inflation.
By implementing the QE program, the central bank buys a specific quantity of bonds from financial institutions without taking into account the interest rate. The aim is not to reduce the interest rate, stimulating the demand for loans, but to immediately inject money into the economy, stimulating the demand for goods and thus making the money flow faster and more frequently. The main risk associated with QE is the possibility to accelerate inflation if too much money is emitted. Therefore, the regulator needs to strictly control the related currency. Due to that fact, the central banks of the European Unit have transferred authority for the QE programs of the ECB.
Initially, QE plans were developed specifically for the U.S., where from November 2008 to October 2014, $3.6 trillion was injected into the country's economy. It resulted in an increase of the American stock market late 2010, which in turn spurred growth in consumption in the U.S., and with it the strengthening of the national economy by the end of the same year.
As per the IMF, the policy of QE implemented by the central banks of developed countries since the beginning of the financial crisis has provided the cut of systemic risks and led to the increase of confidence in the market and reduction of the risk of G7 countries recession.
Speaking about the side effects, the first one is an inflationary which can appear with some time lag. However, there may also be a population-friendly outcome if GDP growth per capita exceeds the percentage of money injected by the Central Bank, backed up essentially only by "all-inclusive" papers. This effect can occur if, due to the same raised money supply, productivity per unit of money also increases. Then this increase in debt will be covered by the growth of GDP, which will neutralize inflation. Furthermore, that can only arise in case banks give out loans, rather than accumulate cash in their own country, as we usually do. Add here high inflation, panic from the upcoming inflation, to the periodic waves of which everyone is already used to, the bankers' frivolity on our production, 50% of GDP "in the shadow".
QE helps the country's exporters and debtors, whose debts are designated in the local currency, lower the debt. The devaluation of the national currency also harms importers as the prices of imported goods rise.
All the same, the injected funds can be utilized by banks to invest in emerging, commodity, and commodity markets, which have difficulties in financing, not in the form of loans to local businesses.
History of Quantitative Easing
Quantitative easing was first implemented by the central bank of Japan to stop deflation after its financial crisis of the 1990s. There is disagreement over whether the stimulus to the Japanese economy was the expected effect of these measures.
Later, throughout and following the 2008-2009 worldwide economic crisis, the implementation of QE has become more often used. For example, Japan was followed by the US, UK, Eurozone, Switzerland, and Sweden.
In 2008, the world economy faced the worst financial crisis after the Great Depression. The crisis, which started with the US real estate market, rapid expanse to the financial sector, and then to the world economy. This led to a drop in banking sector liquidity, bankruptcy of investment and commercial banks, insurance companies, mortgage lenders, and some companies with a high debt burden. Also, the recession affected the major countries of Europe and Asia, which invested in the U.S. real estate sector or mortgage bonds, destroying more than 30% of GDP in some countries. The result was a slowdown in the global economy.
Stages of quantitative easing in the US
- QE1 (December 2008 - June 2010)
Since the beginning of the global crisis, the Federal Reserve System has launched several rounds of QE to steer the economy in the right direction. The Fed began to build up its balance sheet by buying government securities and mortgage-backed securities. The initial stage of QE started in November 2008. The Fed offered to buyback $100 billion in Mae bonds and about $500 billion in mortgage-backed securities. The first round of QE was continued in March 2009, when the Fed expanded the program by $850 billion to buy mortgage bonds and GSE debts. Besides, the Fed also allocated another $300bn to long-term treasury bonds.
- QE2 (November 2010 - June 2011)
In November 2010, the Fed stated an extra bond-buying program - QE2. It was foreseen that by the end of 2011 the regulator would buy $600bn worth of bonds. However, in September 2011 the Federal Reserve originated a new program named "Operation Twist". Its goal was to reduce long-term interest rates because the mortgage rate and long-term loans depend on the yield on the long section of the US Treasuries curve.
- Operation twist (September 2011 - December 2012).
In September 2011 the Fed launched "Operation Twist", which consisted of 2 key aspects. First, as the Fed redeemed short-term securities in its portfolio, the regulator reinvested the funds it received in long-term loans. Secondly, the Fed activated purchases of MBS and US Treasuries. Both measures are created to support the inactive real estate market and stimulate corporate lending. Under Operation Twist, the Fed purchased $400bn in treasury bonds with maturities ranging from 72 to 360 months and sold the same amount of bonds with maturities ranging from 3-36 months. Consequently, the duration of the portfolio increased.
- QE3 (September 2012 - October 2014)
QE3 assumes the purchase of bonds worth $40 billion a month. The expiration period of the program was not known from the beginning, the Fed intended to assess the dynamics of the economy, and it was economic indicators that were crucial at the end date. Meanwhile, the Fed continued the existing policy known as Operation Twist. Together, the two programs increased the volume of long-term debt securities on the regulator's balance sheet by $85 billion a month. Also, the Fed plans to keep short-term interest rates at "extremely low levels" until mid-2015. Previously, the Fed predicted that rates will remain low until the end of 2014.
How long will QE3 last? It all depends on labor market indicators. The goal of QE3 is to significantly improve the labor market: to increase the rate of wage growth and reduce unemployment.
- QE4 (January 2013 - October 2014).
In December 2012 the Fed announced that it will get a sum of $85bn in long-term US Treasuries and MBS. He confirmed his intention by promising to keep the purchase until one of the two conditions is met. Either the U6 unemployment rate should decline below 6.5% or PCE inflation should rise above 2.5%. Since QE4 is only an addition of QE3, some economists still describe it as QE3, others name it "QE Infinity" since the program doesn't have a clear expiration date.
As for Europe, according to a report by the Bank of England, the £200 billion bond buyback it made between March and November 2009 increased UK annual production by around 1.5%-2%. The Bank estimates that this means that the results of the program were "economically significant".
- Fed 2020 - Response to the Coronavirus Crisis
The coronavirus pandemic and the following financial crisis have forced many nations to forget about globalization and start saving their economies. Trying to support households and businesses in difficult times, many countries are "launching printing presses", that is, issuing additional money. Typically, this measure helps the most vulnerable people and businesses to secure their livelihoods in the short term, and in the longer term it accelerates inflation while revitalizing the economy. But it is one thing when such measures are used by small economies and their local currencies, and quite another thing when the "printing press" includes issuers of world currencies.
Early in the epidemic, in mid-March, the U.S. Federal Reserve stated its readiness to "use its full range of tools to boost the flow of credit to households and businesses. And first of all - about the intention to purchase treasury securities for minimum $500 billion and mortgage securities for at least $200 billion. Next, the Federal Reserve stated that over $2.3 trillion, rather than $700 billion, would be directed for this purpose.
The Fed announced related measures on March 15 to support the credit needs of households and businesses. The Fed encouraged depository institutions to borrow from the discount window by lowering the original loan rate (the discount window borrowing rate for banks) by 150 basis points, including a 50-basis point narrowing relative to the fed funds rate. The Fed further supported lending by reducing reserve requirements to zero and by encouraging the use of intraday credit extended by Reserve Banks for facilitating payments.
The Fed also took several supervisory and regulatory actions in recent weeks to support financial institutions and the economy. It temporarily relaxed the leverage ratio that large and community banks have to maintain, it encouraged banks to use their capital and liquidity buffers to lend to households and businesses safely and soundly, and it offered regulatory reporting relief to small financial institutions. The Fed also encouraged banks, savings associations, and credit unions to offer responsible small-dollar loans to consumers and small businesses and to work constructively with borrowers affected by COVID-19.
Sequentially, how or even if traders take advantage of the QE program will come down to trading styles and financial goals. In saying that, shares, currencies and indices may be the most reasonable options for those traders willing to get the most out of the current chaos on the financial markets.
ECB 2015
The QE program, in which the ECB bought assets - from government bonds to corporate bonds - and injected €2.6 trillion into the financial system, ended in December 2018. The ECB sees the risks of a slowdown in the eurozone economy, which it has been trying to spur for three years, flooding with problems with money, and does not intend to raise interest rates at least until next summer, according to Draghi.
Nevertheless, the era of constant pumping of money, which lowered the value of money to almost zero, collapsed the euro to a 12-year low and allowed Germany to borrow money for the budget at a negative rate, which will finally become a thing of the past.
ECB started QE in March 2015 - three months after a similar program was curtailed by the US Federal Reserve. In the first year, it bought up assets by 60 billion euros per month, then increased the "dose" to 80 billion, then in March 2017 began its smooth decline - first to 60 billion euros, then to 30 billion, from September to 15 billion and finally to zero.
For three years, the eurozone central bank bought back from investors bonds of Germany for 515 billion euros, France - for 417 billion, Italy - for 363 billion, Spain - for 229 billion euros, de facto financing their budgets from the "printing press.
The ECB money successfully replaced the injections from the Fed. In general, taking into account the Bank of Japan, the Bank of England, and the People's Bank of China - for 10 years of stimulating policy the world's central banks poured out $16 trillion to financial markets, analysts of Bank of America Merrill Lynch calculated.
This is "certainly the largest monetary experiment in the history of the world," wrote in a letter to investors in 2016 the head of the fund RIT Capital Partners Lord Jacob Rothschild.
What happened can be compared with the "supernova explosion," says BofA strategist Mike Harnett: a record issue of money in history has turned into a tsunami of liquidity, which poured into the financial markets, causing their rapid growth: the U.S. stock market took off 4.5 times, and its capitalization increased by $ 17.5 trillion; pan-European index EuroStoxx50 - 1.8 times; the yield of bonds of developed countries for the first time in history became negative.
The end of quantitative easing?
Like we all know, the Central Bank of Europe voted to cease monetary support for financial institutions in the European Unit in late 2018. Despite that fact, ECB carried on its course on low-interest rates. Needless to say, the current situation calls into question if the time was chosen properly. Especially keeping in mind that trade wars, coronavirus pandemic and Brexit can`t but slow the economy.
As a result of the abovementioned facts, ECB was reluctant to think of new stimulus policies and reduction of the interest rate. One way or another, paying attention to the US Fed reaction to the coronavirus crisis and the coming rate cut we have to notice that another QE is more likely to be launched shortly.
Criticism
Many experts express concern that QE is a kind of delay in solving more serious structural problems, which will eventually lead to a worsening of the economy. Some potential drawbacks:
Inflation: The expansion in the funds supply caused by QE naturally creates inflation. Product competition will increase due to the large circulation of money, but not due to an increased supply of goods. The higher the demand, the higher the prices. If not controlled properly, the inflation rate of rising inflation can quickly lead to hyperinflation.
No forced lending: In QE, commercial banks should utilize the funds they get from the central bank to give more loans. But this process does not oblige them to do so. For example, when QE was originally practiced in the U.S. after the 2008 financial crisis, many banks kept their newfound wealth with them instead of spreading it.
A lot of debt: More borrowing can cause businesses and consumers to borrow more than they can afford, which can have negative economic consequences.
Impacts on other investment instruments: The bond market often reacts negatively to sudden changes and instability, which is quite common after a QE.
Moreover, countries with weak domestic economies and current external account deficits are particularly vulnerable.
Quantitative Easing – Forex
In the currency market conditions there are several reactions to fundamental news. It can be an instant jump (the news is being sold, there is an announcement of changes and possible adjustments of prices).
So, what happens with the currency markets when quantitative easing is announced?First of all, there is increased inflation in the market. As a result, the supply increases, and the price decreases. But in reality, everything happened a little differently. A vivid example is the events of 2015. The European Union announced the introduction of easing, the price of the euro-dollar pair fell by more than 500 points. The price has not changed for several months.
The situation was different in the USA in 2008. During the introduction of quantitative easing, the euro-dollar pair added 2000 points. During the next month the price returned to its original
level, and during half a year it was in a state of growth, as the pair had to enter the same range.
First of all, in the Forex market the price for overvalued currency is reset. Later on, the value of the currency pair is gradually growing, despite theoretical calculations.
As for GBP, it fell 600 points in March 2009 within the following weeks.
Moreover, when Japan launched a new cycle of QE in 2013, it provoked the JPY to decrease 900 pips against the US dollar.
All in all, any of these events was an incredible opportunity for Forex traders to increase the account balance, trading both directions.
Quantitative Easing - Economic growth
Every economy is cyclical and periodically goes through four stages in its development, one of which is economic growth. Growth begins after the economic bottom stage and continues until it peaks, after which the recession phase begins.
Since the main factor of economic growth is the increase in state revenues, the main indicator is the one that characterizes these revenues. And it is called GDP (Gross Domestic Product).
GDP is an indicator that characterizes the total value of goods and services officially produced by the state and all economic entities within it. That is, it is the monetary equivalent of all sold goods and services, displayed in the reports of enterprises and entrepreneurs
It is noteworthy that the same product can be taken into account in GDP calculation several times. For example, if it has been resold or transformed many times during processing.
Suppose that a producer produces a product, sells it to a large wholesale buyer, sells it to a small wholesale buyer, sells it to a retail store, and sells it to a consumer.
Or the company produces oil, sells it to the refinery, the latter produces gasoline, sells it wholesale, the wholesaler sells it to gas stations, and the gas stations to consumers.
In both cases, each sales value is included in GDP.
Depending on the main factors of economic growth, there are two types of GDP.
Extensive economic growth - occurs at the expense of increased production of resources. The country uses its natural potential by increasing the extraction of minerals, selling, and processing them, thus increasing its revenues. The benefits of this growth option are very questionable: the country lags in its development and simply gets everything that nature has given it. At some point, resources will run out, and then the country will face a steeper economic decline, as outdated technologies will not allow for good earnings without the same amount of resources.
Intensive economic growth - occurs at the expense of improvement of production technologies, the introduction of innovations that allow to produce and sell more with the same or even fewer resources. This is a more preferable variant of the country's economic growth, which, by the way, has a better effect on the growth of the citizens' living standards.
The money creation trap!
Now that the money will be printed not just a lot, but a VERY lot (you thought it was already a lot, but there will be a lot more), there are only two ways out: either hyper... okay, very fast further inflation of assets. Or finally, the long-awaited galloping inflation of consumer prices. And finally, the seemingly unbelievable and very bad: both of them. However, a flexible modern economy can respond to a jump in the final demand for free loans (if the Basels do not give them to banks, the shadow banking system and financial structures under the producers will do it for them) with a rapid increase in supply - until resource starvation (including labor) in such an explosion will not work. And then inflation will take revenge. Yes, it will!
As a result, we get either another variant of subprime crisis (for example, junk on a new turn, in colossal volumes and with a new wave of securitization) or a classic overproduction crisis... ...or both.
How will the world monetary authorities respond to this pleasant event? They won`t! What's the point of adding more air to the atmosphere, generated somehow? Well, won't some Trump Junior cancel all taxes... so the Fed can monetize the government debt again. Air to the atmosphere.
The liquidity trap, as it is. We got it. If we can't find a non-conventional way out.
When the number of dollars in turnover increases significantly, they should be devalued, because the number of assets has remained the same and the amount of dollars has increased. But this does not happen during crises. At this time the liquidity is quite low, there are few buyers, it is very difficult to sell something, so the value of assets even falls. We see that stocks, real estate, etc. are becoming cheaper because there are not many people who want to buy this during the crisis. And there are two opposite trends: because of the excessive amount of dollars, prices should have gone up, and because of the crisis, prices should have gone down. And which of these opposite trends will overpower - amid the crisis, it's hard to say. But after the crisis, the demand for risks will increase. And since there will be a lot of money, prices can rise - both for investment assets and for consumer goods. And here it is important, firstly, how long the crisis will last (and nobody will say that today), and secondly, how the countries that used the policy of QE will come out of the crisis. We saw, for example, that QE3 ended up with a decrease in the number of dollars in turnover. The Fed withdrew them by not buying new treasury bonds when the old ones were being repaid.
Quantitative Easing - Banking system
Of course, the banking system can make a difference and affect the supply of money, but we should remember that the demand cannot be raised unless the economic situation is enhanced as a whole. Consequently, the government can only affect the money demand after providing reliable and solid economic conditions. A decrease in demand suggests less cash inflow than a developing economy needs.
Conclusion
Information on the implementation of the quantitative easing program is constantly being analyzed. It should be noted that the results of aggressive stimulation of the economy are not final as the data are compared and specialists are in search of optimal solutions.
Different world economies, currencies of different countries reacted differently to the use of quantitative easing methods. It may take years to formulate final data for a certain period of time.
The concept of quantitative easing is quite aggressive, but at the same time effective. A certain amount of money should be introduced from time to time. As a rule, the amount of input is determined by specialists according to the inflation rate, which needs constant support. It is important to take into account the specificity of cash circulation.
A greater number of countries that have used quantitative easing attempts have resulted in inflation or even deflation. Trillions of dollars were introduced into the economies of many countries. But the outcome was radically different. Developed economies recovered quite quickly from the crisis, but the migration of money across borders can create financial problems on a multi-country scale.
