Thursday, April 30, 2009

Quantitative easing: What is it?

What is quantitative easing?

Quantitative easing is a term used to describe a process whereby central banks "print" more money (money is generally created electronically these days) and use it to buy assets such as government and corporate bonds held by commercial banks and other financial institutions. Buying the bonds decreases their supply in the market and pushes up prices, which in turn drives down yields or interest rates. Since bond yields are used to set long-term interest rates for mortgages and most business lending, this should have the effect of reducing the cost of borrowing. By selling the bonds, the financial institutions get an infusion of cash that enables them to lend more money and help generate economic activity.

Why is quantitative easing being used?

Normally central banks try to increase the amount of lending and economic activity by cutting interest rates. But with central bank rates at historic lows — 0.25 per cent in Canada and 0 to 0.25 per cent in the U.S. — the availability of credit remains tight and demand relatively weak. So policy makers find themselves having to come up with other ways to boost lending and spending.

Quantitative easing: What is it?Bank of Canada Governor Mark Carney has expressed reservations about quantitative easing.(Sean Kilpatrick/Canadian Press)Who is using the process?

The U.S. Federal Reserve and the Bank of England are both engaged in quantitative easing, with the U.S. central bank indicating it will buy up more than a trillion dollars worth of debt. The Bank of Canada is not and has expressed reservations about the process, which economists view as an experiment.

Will it work?

It's too early to say. Reducing central bank rates practically to zero was supposed to unlock credit and spur borrowing, but that hasn't happened to the degree policy makers feel is necessary to revive the economy. Whether it can be accomplished by buying up bonds remains to be seen.

Are there risks involved?

Quantitative easing is seen as risky because creating money out of thin air and pumping it into the economy could lead to a higher rate of inflation than is deemed desirable and devalue the currency. At the same time, if the strategy isn't pursued aggressively enough, it won't have the desired effect. Banks will remain reluctant to lend and spending will remain weak.