Following the global financial crisis in 2007, Quantitative Easing (QE) has become one of the main tools used by the UK and US to ward off further entrenchment. So crucial is QE to monetary policy that when US Federal Reserve chairman Ben Bernanke remarked the practice could end by 2014, the FTSE 100 sank more than 2% as investors raced to dump shares.
But is there any evidence that QE actually works?
Research by Professor Chris Martin has analysed the effect of QE on financial markets and on the ‘real economy’ of output, employment and inflation.
What is Quantitative Easing?
Quantitative Easing (QE) has been used by central banks to stimulate economies when standard monetary policy becomes ineffective.
A central bank implements QE by buying financial assets from commercial banks and other private institutions, using money it has simply created out of thin air - increasing the money supply.
The financial crisis that began in July 2007 threatened to bring down banking systems in major economies. Major disruption in the financial sector led to contractions in credit to the private sector.
The depth of the crisis made loosening of monetary policy essential. But by early 2009 further loosening using conventional policy was no longer feasible, as interest rates had been cut to near zero in all major economies.
QE was introduced in the UK in March 2009, initially as a means of supporting the financial system, but increasingly with the aim of boosting aggregate demand. It has so far cost £375 billion, about 20% of GDP.
Have these policy initiatives worked?
The initiatives have had an impact on financial markets. Event studies – which look at movements in bond rates immediately after QE announcements - suggest that the first round of QE reduced the yield of government bond rates by up to 100 basis points (1%) in the US and 50 basis points (0.5%) in the UK, making it cheaper for business to raise capital.
Econometric studies - which provide a detailed assessment of the effects on both financial markets and the ‘real economy’ - suggest smaller but still marked effects.
However, subsequent rounds of QE seem to have had a smaller ipmact. It is likely that the effects were short-term, being reversed several weeks after the initial purchases.
The impact of QE on the ‘real economy’ is less clear. The financial crisis is a recent event and there is not yet sufficient data on output and employment to conduct a full investigation.
Should Central Banks continue with QE?
The evidence suggests that QE was a valuable tool at the height of the financial crisis in 2009. It probably helped stabilise markets and contributed to preventing a recession becoming a depression.
However, QE does not seem to be an effective policy tool for bringing major economies out of stagnation.
The research found that:
- QE does reduce interest rates on government bonds, especially those of longer duration
- this effect may be temporary and limited if bond rates are already low
- QE helped to stabilise the financial system in late 2008 and 2009, preventing even larger declines in output than were experienced
- there is little evidence that QE has encouraged economic growth
- alternative policy options need to be considered
This suggests that while Quantitative Easing has produced a limited but temporary gain for the financial sector, it has been of practically no help to the wider business community or individuals and families struggling against inflation and unemployment.
Despite the affection investors may have for it as a financial lever, QE looks unlikely be the answer to the economic problems of the modern age.