When cutting interest rates to zero isn’t enough, central banks have another tool: buying enormous amounts of bonds. Here’s how quantitative easing works, and why it’s so controversial.
Central banks usually support the economy by cutting short-term interest rates, such as the Reserve Bank’s cash rate. But once rates are close to zero, they can’t go much lower.
Quantitative easing, or QE, is an extra tool. The central bank creates new money electronically and uses it to buy large amounts of bonds, usually government bonds, from banks and investors.
How it works
When a central bank buys bonds in large quantities, it pushes up their prices and pushes down their yields, or interest rates. Because many loans and investments are priced off government bond yields, that helps lower borrowing costs across the economy.
The banks and investors that sell their bonds receive cash, which they may lend or invest elsewhere, supporting spending and asset prices.
It’s often described as “printing money”, although no physical notes are printed. The central bank simply credits the sellers’ accounts with newly created money.
When it has been used
Japan used a form of QE in the early 2000s. It became widespread after the global financial crisis, when the U.S. Federal Reserve, the Bank of England and later the European Central Bank bought trillions of dollars of bonds.
During the COVID-19 pandemic, central banks used it again on a huge scale. The Reserve Bank of Australia, which had never used QE before, cut the cash rate to 0.1% and bought hundreds of billions of dollars of Australian government bonds. It also targeted the yield on three-year government bonds, and offered banks cheap funding to keep lending.
The side effects
Supporters say QE helped prevent deeper recessions and financial collapses.
Critics argue it pushed up the prices of shares, property and other assets, benefiting people who already owned them and making it harder for younger people to buy homes.
Some economists also believe the huge amount of money created during the pandemic contributed to the surge in inflation in 2021 and 2022.
QE can also leave central banks with large losses when interest rates rise. The Reserve Bank’s balance sheet suffered big losses on its bond holdings after it raised rates.
Quantitative tightening
The reverse is known as quantitative tightening. Central banks shrink their holdings of bonds, either by selling them or by letting them mature without replacing them, which removes money from the financial system.
Since inflation surged, most major central banks have been shrinking their bond holdings, a process that tends to push long-term interest rates up.
