April 11, 2015    4 minute read

Quantitative Easing 101

   April 11, 2015    4 minute read

Quantitative Easing 101

Quantitative easing (QE) is an unconventional form of monetary policy (used when standard measures have become ineffective) where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to stimulate the economy in a direct way and to return inflation to a target rate of approximately 2%.

The QE was used in the past by the USA (in 2009) and Japan (in 2013), and in both countries the economy is now experiencing the positive effects of this measure. In Europe, QE officially started last March, when the European Central Bank (ECB) pumped the first €60 billion into the financial markets; which shall be repeated each month until September 2016, when the total amount pumped into the economy would be approximately €1100 billion. The measure aims to revive the credit market, to reduce the interest rates and fight deflation. In summary, it aims to boost and revive the economy now. The policy was promoted by the ECB President Mario Draghi and was approved despite opposition from powerful countries including Germany, Luxembourg and Holland.

Analysis of the process

The first step of the process sees the ECB as the main actor. Indeed, the ECB pumps liquidity into the market, increasing the quantity of money in circulation. The ECB buys bonds (government bonds above all), on the secondary market from banks and other financial institution. The direct consequences expected by the ECB are a decrease of yields, a depreciation of the euro and an increase of inflation. Delving deeper, the ECB buys government bonds, feeding market demand and thus increasing their value. As the price increases the yield decreases, which consists of a fall in interest rates and a modulation of central banks’ balances, whilst the euro depreciation means above all an increase of the euro-area competitiveness.

QE

The current situation

A month since Draghi launched the QE programme, some objectives are demonstrating fruition, whilst others still have a long way to go. On the one hand, the euro has depreciated:

On the other hand, no significant rise of the inflation has been observed. In March, deflation of the euro-area was confirmed (-0.1% on an annual basis) and economists are now split into two lines of thought: the former believes the situation will get worse, while the latter trusts in a positive development throughout the upcoming months.

In the end, the first month of QE points to a paradox. The interest rates of some bonds decreased in such way that the ECB, theoretically, will not be able to purchase them in the near future. In particular, the ECB buys securities on the open market only if the expiration date is between 2 and 30 years and if their interest rate is above the rate established by the ECB on deposit accounts. This last condition is the reason for the paradox. Indeed, at the moment the interest rate on deposit accounts is fixed by the ECB to -0.2%, while the rates of some bonds of Germany, Finland and Holland record a lower level. The direct consequence is that a lot of bonds in the euro-area can’t be purchased by ECB because their rates pass the lower bound.

All things considered, the QE programme is bringing about positive effects in all countries that have previously adopted the measure, and Europe the ECB is pulling out all the stops. The main indexes of the euro area (DAX, CAC, FTSE-MIB) are on the rise, the euro is depreciating and even if, for the moment, the inflation is not risen, all data provides hopes that in upcoming months inflation may begin to creep upwards.

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