Quantitative easing is a distinct class of monetary policy that central banks recently started implementing because the traditional way of conducting monetary policy, which involves moving short-term interest rates, was no longer workable.
Central banks regularly move short-term interest rates to control the prevailing interest rates in the economy through the interbank market – rates at which banks can borrow from one another. After the financial crisis of 2008, however, the short-term nominal interest rate in many countries approached what is known as the lower zero limit. The short-term interest rate got so close to zero that it became essentially impossible to lower it any further to stimulate the economy. The lower zero limit means that the nominal interest rate remains above zero. Hence, standard monetary policy is limited by this zero floor.
The moment central banks like the Federal Reserve realized that they could no longer use the traditional way of conducting monetary policy, they developed another approach called quantitative easing.
Constituent of quantitative easing
First of all, quantitative easing involves changing the types of assets the central bank is buying. The conventional approach to moving short-term interest rates is based on buying risk-free, short-term assets – generally government bonds. Instead, in quantitative easing, the types of assets the central bank buys vary. These can be bonds with longer maturities and very different types of assets, such as securities issued by private companies. However, most of the time, it depends on what kind of goal the central bank has in mind.
Let’s consider for a moment what goal the central bank is achieving by buying long-term bonds. Buying long-term bonds increases the price of those bonds and lowers long-term interest rates. So the first effect of these nontraditional purchases is that they change expectations about future short-term interest rates. This is because long-term interest rates, once adjusted for risk, reflect the expected course of future short-term interest rates.
Why does lowering expected future short-term interest rates make sense?
Well, because economic decisions are made by forward-looking actors for whom expectations of future short-term interest rates matter. Therefore, by shifting expectations, the central bank can avoid the problem that the current short-term interest rate cannot be lowered further because it is already at zero. However, it can still lower expectations about future short-term interest rates by lowering the long-term interest rate.
The government can also buy stocks issued by private companies. In this case, there are two effects. There’s the effect on maturities that we mentioned. But there is another significant effect. When the central bank starts purchasing securities that are not completely risk-free, it attempts to influence the risk premium and provides liquidity to the banking sector. In this case, not only does the central bank provide an anchor for future short-term interest rates, but it also seeks to lower the risk premium and add some stability to the financial system.