Quantitative Easing and Quantitative Tightening

July 2024 by André Themudo

Quantitative Easing and Quantitative Tightening: unconventional monetary policy strategies

In monetary policy, central banks use various instruments to manage economic stability and growth. Among these instruments, Quantitative Easing (QE) and Quantitative Tightening (QT) are examples of unconventional monetary policies. Unlike traditional methods, which typically involve adjusting short-term interest rates, QE and QT target the broader financial environment by changing the central bank's balance sheet. 

QE and QT:  what they are and how they work

Quantitative Easing is a monetary policy that consists of a central bank purchasing long-term securities, such as government bonds and mortgage securitization bonds, to increase the money supply and lower long-term interest rates. The main aim of QE is to stimulate economic activity by making borrowing cheaper and encouraging investment and consumption. To do this, it lowers the interest rate on the bonds bought by the central bank - since by buying these bonds, their price increases and the interest rate, which moves inversely to the price, decreases. This method is used when traditional policy instruments, such as reducing short-term rates, become ineffective, especially when rates are already close to zero (##1##Engemann, 2019##1##).

Quantitative Tightening , on the other hand, implies that the bank reduces its balance sheet by selling securities or allowing them to mature without reinvesting the profit. The aim of QT is to reduce the money supply and increase long-term interest rates, thereby slowing down economic activity and controlling inflation. QT is usually implemented after periods of QE to normalize monetary policy and prevent the economy from overheating (##1##Chien ##1##et al., 2024).

Historical examples

2008 financial crisis

The Federal Reserve first implemented QE during the 2008 financial crisis. Faced with a severe recession and near-zero interest rates, the Fed began purchasing large quantities of long-term bonds to inject liquidity into the financial system and encourage lending and investment. The Fed carried out several rounds of QE from 2008 to 2014, significantly expanding its balance sheet to support the economy (##1##Estenssoro ##1##et al., 2023; ##1##Waller, 2024##1##).

COVID-19 pandemic

In response to the COVID-19 pandemic, the Fed once again turned to QE in March 2020. This time, the purchases were even larger and more extensive, including not only government bonds and mortgage securitization bonds, but also corporate bonds. The aim was to stabilize markets, support economic recovery, and ensure the smooth functioning of credit markets during unprecedented economic disruptions (##1##Engemann, 2019)##1##.

Eurozone debt crisis of 2015

The European Central Bank (ECB) also adopted QE in response to the eurozone debt crisis in 2015 (##1##European Central Bank [ECB], n.d. ##1##). The ECB's Asset Purchase Program targeted government and private sector obligations to stabilize the economy and prevent deflation. During the COVID-19 pandemic, the ECB launched the Pandemic Emergency Purchase Program (PEPP) to further support eurozone economies under severe pressure (##1##Engemann, 2019##1##).

The Federal Reserve began QT in October 2017, following extensive QE programs that had inflated its balance sheet. The aim was to normalize monetary policy by gradually reducing its holdings of government bonds and mortgage-backed securities, thus tightening financial conditions to prevent the economy from overheating as it recovered from the financial crisis (##1##Chien ##1##et al., 2024). The ECB announced plans to reduce asset purchases in 2018, indicating a shift towards tightening as the European economy showed signs of recovery. However, due to slower-than-expected growth and persistent low inflation, the ECB's Quantitative Tightening efforts were more cautious and shorter in duration compared to the Fed's (##1##Chien et al., 2024##1##)​.

Effectiveness and challenges

Both QE and QT have their challenges. The effectiveness of QE can be limited if central banks hoard additional liquidity instead of lending it out, or if low interest rates fail to sufficiently stimulate demand. Furthermore, prolonged QE can lead to speculative asset bubbles and an increase in income inequality, since profits are often disproportionately earned by holders of financial assets (##1##Estenssoro ##1##et al., 2023).

QT must be carried out carefully to avoid disturbances in the market or an excessive tightening of financial conditions, which could lead to a recession. For example, the Fed set monthly limits on the amount of bonds it would allow to mature in order to ensure a gradual reduction in its balance sheet. QT failures can lead to increased volatility and undermine investor confidence (##1##Chien##1## et al., 2024).

Conclusion

Understanding QE and QT is essential to understanding how central banks manage economic cycles. These policies emphasize the balancing act that central banks perform - stimulating growth during recessions and tightening conditions during expansions to maintain economic stability. As the global economy continues to evolve, these tools will continue to be fundamental to monetary policy strategies, influencing everything from interest rates to the availability of credit in the economy. 

Sources

          Chien, Y., & Stewart, Ashley H. (April 18, 2024). Bank Reserves since the Start of Quantitative Tightening. Federal Reserve Bank of St. Louis. ##1##https://www.stlouisfed.org/on-the-economy/2024/apr/bank-reserves-start-quantitative-tightening##1##
Engemann, Kristie M. (July 17, 2019). What Is Quantitative Tightening? Federal Reserve Bank of St. Louis. ##1##https://www.stlouisfed.org/open-vault/2019/july/what-is-quantitative-tightening##1##
European Central Bank - eurosystem. (n.d.) Asset purchase programmes. Retrieved July 27, 2024, from ##1##https://www.ecb.europa.eu/mopo/implement/app/html/index.en.html##1##
Estenssoro, Amalia, & Kliesen, Kevin L. (August 23, 2023). The Mechanics of Fed Balance Sheet Normalization. Economic Research Federal Reserve Bank of St. Louis, USA. ##1##https://research.stlouisfed.org/publications/economic-synopses/2023/08/23/the-mechanics-of-fed-balance-sheet-normalization##1##
Waller, Christopher J. (March 1, 2024). Thoughts on Quantitative Tightening, Including Remarks on the Paper 'Quantitative Tightening around the Globe: What Have We Learned?'. Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/newsevents/speech/waller20240301a.htm