After the global financial crisis of 2008, the central banks in the United States and the eurozone were trapped in an unusual scenario. There was a lack of demand due to the recession, and it was imperative on the central banks’ part to boost confidence. Traditionally the tool used by central banks is lowering the interest rates hence encourage the businesses and people to borrow and spend. But this time the interest rates, already at the lowest levels possible, could not be lowered further. Enter the new tool used by these central banks: Quantitative Easing (QE).
What Is Quantitative Easing?
The Federal Reserves (Fed) and the European Central Bank (ECB) are on the path of QE long-term. QE started with the purpose of boosting consumer confidence in the wake of the global financial crisis of 2008. QE is the way by which central banks pump money into the market by way of bond purchase.
This money then can be utilised to spend on sectors like housing to boost the prices and the consumer confidence. The ECB has been generating around €60bn-€80bn per month out of thin air to boost consumer confidence. One way to interpret this strategy is the goal of increasing inflation to the desired level.
For any economy to grow at a steady rate, there must be a certain level of inflation (which varies from country to country). The eurozone, the US and the Japanese economies have been struggling with the menace of low inflation for a significant period. So, QE is supposed to help on that front too.
QE’s Effect On The Bond Market
The aim is to understand how QE affects the bond market. After a brief description of what QE is and why it is needed, one now shifts to the implications for the bond market. The bonds issued by the government are the safest option for any investor. The money raised by the government can be utilised in the public sector for infrastructure.
When central banks walk on the path of QE, they are printing money and investing in the bond market. Since bonds are the safest option available, it removes the uncertainty of market risk.
Now consider a simple example: in the absence of QE, there was only $100 to be invested in bonds, but now, with QE there would be an additional $200. This increased amount of money would follow the same path of investment that is government bonds. The rule of supply and demand suggests the that more money following the same goods (here bonds) the greater the increase in the price of the bonds.
Since the prices of bonds and the yield are in inverse relation, higher prices would lead to lower yields for the investors. Here it would be necessary to know that the aim of QE is not to generate more returns, but rather it is just to build the steady growth picture in the minds of the people.
QE’s Effect On Inflation
From the earlier example, as one now has higher bond prices and lower yields, the people who were already invested in the bond market earlier would see their return deteriorating. Another blow would be higher inflation.
Due to QE, there would be excess liquidity in the market causing higher inflation. Both would wreak havoc for senior citizens and people who only invest in government bonds.
Another factor to consider here is the lower yield in the bonds market, which would make foreign investors shy away from investing in the economy, as there would be more attractive investment options available in other parts of the world.
So, unless QE achieves its main goal of boosting consumer confidence, it will lead to a downwards spiral, just like the one witnessed in the eurozone and Japan.