Quantitative easing (QE) is an unconventional monetary policy employed by central banks to invigorate the economy when traditional monetary measures are ineffective. It is often informally referred to as “printing money,” although no physical banknotes are actually produced. Instead, money is electronically “created” or “keystroked.” Terms like “keystroking money” or “typing up money” are more precise than “printing money.” The goal of QE is to elevate the price of government bonds while simultaneously lowering their yields. This strategy encourages banks to invest in riskier assets and increase lending to businesses and individuals.

QE essentially describes a central bank purchasing “assets” from commercial banks and other private entities. These “assets” are usually limited to government bonds, but depending on the central bank, other assets like mortgage-backed securities (MBS) and corporate bonds may also be included. For instance, a U.S. pension fund might sell Treasury bonds to the Federal Reserve (Fed) and, in return, receive a deposit (money) in an account at a major bank, such as Bank of America. Consequently, Bank of America acquires a new deposit (a liability to the pension fund) and a new asset (central bank reserves from the Fed).

QE simultaneously increases the amount of: Reserves (the “central bank money” that banks use for interbank transactions) and Deposits (the “commercial bank money” held in the accounts of individuals and companies). Only the “commercial bank money” or deposits can be spent in the real economy. Reserves or “central bank money” are utilized solely for “internal purposes,” meaning they can only be exchanged between commercial banks and the central bank. Think of deposits (commercial bank money) as “outside money” and reserves (central bank money) as “inside money.” Deposits can be used as currency in the real world, while reserves are confined to the banking sector, which includes commercial banks and the central bank.

A central bank implements quantitative easing by acquiring financial assets from commercial banks, private institutions, and corporate bonds. This purchasing action generates new reserves (“central bank money”) that are intended to be lent out into the real (non-financial) economy, providing individuals and companies with access to capital they might not otherwise have. In essence, QE has two primary objectives: to lower long-term interest rates to promote borrowing and economic growth, and to encourage more risk-taking by directing investors toward stocks and non-government bonds. Additionally, QE serves as a strong signaling mechanism, reinforcing the Fed’s guidance on future interest rates. By purchasing long-term assets, the Fed “convinces” investors that it is committed to maintaining lower rates for an extended period.

The issue, however, is that this newly created money did not flow into the real (non-financial) economy; instead, it returned to the financial sector. The funds generated through QE were used to buy government bonds from the financial markets, leading to all-time highs in both the bond and stock markets. Another effect of QE is its attempt to “control” long-term interest rates. Typically, central banks can only “influence” long-term rates indirectly by managing short-term rates. However, with QE, they can attempt to directly control long-term rates. They achieve this by purchasing long-term debt, such as 30-year Treasury bonds. By buying these bonds, they effectively increase demand. When demand outstrips supply, prices rise, and as bond prices increase, their yields decrease. This is how central banks strive to manage long-term interest rates.

In summary, the objective of quantitative easing (QE) is to boost the excess reserves of banks and elevate the prices of the financial assets purchased, which in turn lowers their yields. How does QE function? Governments and central banks aim to maintain a “steady” economy. They seek to promote economic growth without allowing inflation to spiral out of control, while also avoiding stagnation or recession (negative growth). Their goal is to achieve a balanced rate of economic growth. One of the primary tools at their disposal for managing growth is adjusting interest rates. Lower interest rates incentivize individuals and companies to spend rather than save. However, when interest rates are nearly zero, central banks must resort to alternative strategies, such as injecting money directly into the financial system. This process is known as quantitative easing or QE.

The central bank purchases assets, typically government bonds, using money it has “printed” – or more accurately, created electronically. It then utilizes this money to buy bonds from investors like banks or pension funds. This action increases the overall amount of available funds in the financial system. By making more money accessible, the intention is to encourage financial institutions to lend more to businesses and individuals. It can also lead to lower interest rates throughout the economy, even when the central bank’s own rates are already at their lowest. This, in turn, should enable businesses to invest and consumers to spend more, providing a boost to the economy.