What is quantitative easing?
- 22 January 2015
- From the section Business
The European Central Bank has announced action aimed at stimulating the troubled eurozone economy in the face of deflation and recession.
Unlike central banks in the United States and Britain, the ECB has so far resisted implementing a programme of buying government bonds. That is the process known as quantitative easing.
What is QE?
Governments and central banks like there to be "just enough" growth in an economy - not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called "Goldilocks economy" - not too hot, but not too cold.
One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.
But when interest rates are almost at zero, central banks need to adopt different tactics - such as pumping money directly into the economy.
This process is known as quantitative easing or QE.
The central bank buys assets, usually government bonds, with money it has "printed" - or created electronically these days.
It then uses this money to buy bonds from investors such as banks or pension funds using this "new" money, which increases the amount of cash in the financial system, encouraging financial institutions to lend more to businesses and individuals. This in turn should allow them to invest and spend more, hopefully increasing growth.
Why is the ECB taking action now?
Growth in the economies of many countries in the eurozone - referring to the 19 countries that use the euro - has slowed down in recent months, while some are in recession. Further, Europe is facing the spectre of deflation - when prices fall, rather than rise - after the inflation rate fell below zero in December.
Deflation alarms economists because it can quickly become a downward spiral that is difficult to stop. When consumers expect deflation they delay purchases in the hope that prices will fall further, which then leads to a further slowdown in growth and price falls.
Earlier this month, the World Bank warned that the eurozone risked sliding into permanent stagnation.
The ECB has been under pressure for some time to take action, but has faced intense political resistance from Germany in particular. However, it is now widely felt that action is needed.
Have other central banks tried QE?
Both the Bank of England and the US Federal Reserve embarked on QE in the wake of the 2008 financial crisis in an attempt to stimulate economic growth.
QE was first attempted by Japan's central bank to arrest a period of deflation following its financial turmoil in the 1990s. There is disagreement about whether the initiative had the intended effect of stimulating the Japanese economy.
Has QE worked elsewhere?
A Bank of England report estimated that the £200bn ($300bn) worth of bonds it bought between March and November 2009 helped to increase the UK's annual economic output by between 1.5% and 2%. That meant the effects of the programme had been "economically significant", the Bank concluded.
Since starting QE in 2008, the Federal Reserve has bought bonds worth $3.7 trillion, increasing its holdings eight-fold.
The US central bank said in November that it would end its programme of asset purchases because its targets for inflation and reducing unemployment were on track to be met.
However, there remain concerns about the long-term impact of the United States' persistently low inflation rate.
Will it work in the eurozone?
No one knows, but the most significant effect of action by the ECB could be to bring confidence to markets.
With Greek elections on Sunday, ECB bond-buying could support confidence in troubled eurozone members and prevent any fallout from Greek politics affecting other countries.
After five years of economic austerity, most pollsters say the Greeks are poised to reject the EU-imposed cost-cutting and vote for Syriza, which rejects the fiscal crackdown
The idea is that if the ECB is buying bonds from countries such as Italy - as well as those from stronger members such as Germany - investors have little reason to sell such bonds in a rush, even if the economic situation in Greece worsens.
Are there any losers from QE?
QE pushes up the market price of government bonds and reduces the yield paid out to investors. In other words investors have to pay more to get the same income.
This is one reason why UK company pension scheme deficits have increased sharply in recent years. As the yield on bonds has fallen, so the number of bonds needed to generate the same level of pension income has gone up.