Quantitative easing refers to the actions by Central Banks that create liquidity in the economy by printing money. This is usually used by central banks after they fail to inject liquidity in the economy by lowering interest rates. Bank of Japan used this quite a bit to fight deflation and now the Fed seems to be using it too.
The bad effects of deflation make every central bank avoid it. Creating money supply in the economy is the way to create inflation, which, in turn fights deflation. Usually the Fed lowers interest rates to create inflation by boosting borrowing, but after lowering interest rates to 1% or lower, there are not many options left, but print money.
I don’t want money, even at 0%!
The big question is that why wouldn’t banks borrow from the Fed at 0%? At that rate money seems virtually free and why wouldn’tÂ anyone want free money?
The answer is deflation.
During deflationary times the price of all goods and services go down. That means you can buy more with a buck tomorrow, than you can buy today. Since the price of things that money can buy goes down, the value of money itself goes up.
Think of gas prices. If gas was $4 at the pump three months ago and it is $1.50 now, your $1.50 today is equal to $4 of three months back.
Now, imagine that there is a deflation rate of 10% and you borrow $100 at 0%. You will repay $100 in about an year, but you really lose 10%. Since, you could buy much more in one year from now, than today, even borrowing at 0% means that you are losing money.
When banks are not willing to take money at even 0% and credit markets have frozen, the central banks don’t have any other option but print currency.
This is pretty much what the Fed has done with its bailouts. The latest one with the Fed promising to inject $800 billion more to boost credit; points in that direction too.
The biggest risk of such a strategy is the chance that it will create uncontrollable inflation. Till date the total value of the US bailouts amount to $7 trillion! That is 70% of the size of the entire economy and when dealing with such huge sums, anything can go wrong.
I have used the term – print currency, very liberally in this article. Central Banks create liquidity with a wide variety of means, which are much more complex than simply printing currency. However, I believe that all these measures lead to the same impact as printing money and hence the liberal use of the term.