What is quantitative easing and how does it work?
Quantitative easing (QE) became a key tool for central banks after the global financial crisis. It’s used when traditional measures like cutting interest rates aren’t enough. By creating new money electronically and buying financial assets such as government bonds, QE lowers borrowing costs, adds liquidity to markets and helps guide inflation back towards target levels.
For CFD traders, knowing how QE affects asset prices and currencies can help for navigating volatility and spotting potential opportunities.
What is quantitative easing?
Quantitative easing (QE) is a monetary policy tool where central banks buy large amounts of financial assets, usually government bonds, to inject money into the economy and support growth.
In simple terms, QE means a central bank creates new money electronically and uses it to buy assets. The aim is to reduce borrowing costs and boost lending in the economy.
Trading financial instruments, including CFDs, involves significant risk of loss due to leverage.
How does quantitative easing work?
To understand QE, let’s break it into three main parts:
1. Asset purchases
Central banks buy large amounts of financial assets, mainly government bonds, from commercial banks and financial institutions. This increases demand for those bonds and injects new money into the system.
How asset purchasing works:
- Central bank announces QE
- Banks sell bonds to central bank
- New money enters the system
- Market liquidity rises
2. Money creation and reserves
Central banks create new electronic money to pay for these asset purchases. This money is credited to banks’ reserve accounts. Higher reserves may allow banks to lend more – but they’ll only do so if there’s demand and if regulatory requirements are met.
How money creation works:
- Central bank creates new electronic money
- Banks’ reserves rise
- Banks may lend more if conditions allow
- How much lending increases depends on demand, not a fixed formula
3. Lower yields on government bonds
When central banks buy government bonds, bond prices rise and yields fall. Lower yields usually encourage borrowing and push investors towards riskier assets.
How government bond yields work:
- Higher bond prices = lower yields
- Lower yields = cheaper borrowing
- Investors look elsewhere for returns
- Overall borrowing costs fall.
Effects of quantitative easing on markets and the economy
QE can stimulate markets and economies in the short term but may also create risks if used for too long.
1. Influencing long-term interest rates
By increasing demand for long-dated bonds, QE lowers long-term rates compared with short-term ones.
2. Potential impact on inflation
More money in the system can push prices up, though this effect isn’t always immediate or guaranteed.
3. Shifts in investor confidence
QE can influence asset prices and signals supportive policy, which can encourage more risk-taking.
- Potential benefits: supports lending, raises asset prices, stimulates spending.
- Potential risks: may fuel inflation or create asset bubbles
Why do central banks use quantitative easing?
Central banks use QE when cutting interest rates is no longer enough to support the economy.
Stimulating lending
QE aims to make borrowing cheaper and lending more attractive. By boosting banks’ reserves, central banks give them more capacity to lend – though banks will only do so if businesses and households want loans and regulatory rules are met.
How this works:
- Banks hold more reserves
- Lower interest rates encourage borrowing
- Businesses and consumers can access more credit
Supporting inflation targets
Most central banks set an inflation target of around 2%. If inflation falls below this, QE can help push it higher.
How QE supports inflation:
- A larger money supply can raise prices
- Higher asset prices may create a “wealth effect” for some households
- A weaker currency can lift import prices
Addressing economic crises
In deep recessions or emergencies, when interest rates are already close to zero, QE acts as a last-resort tool to keep credit flowing.
Quantitative easing vs quantitative tightening
QE and QT are opposites:
- Quantitative easing (QE): central banks buy assets to add liquidity, lower yields and support growth when inflation is weak.
- Quantitative tightening (QT): central banks sell assets or let them mature to reduce liquidity, usually when inflation is rising.
Below is a brief comparison table.
| Aspect | Quantitative easing (QE) | Quantitative tightening (QT) |
|---|---|---|
| Mechanics | Central bank buys assets, adding reserves | Central bank sells assets or lets them mature, reducing reserves |
| Potential triggers | Weak growth, low inflation | Overheating economy, rising inflation |
| Market impact | Lowers yields, boosts liquidity and asset prices | Raises yields, cuts liquidity, may slow asset-price growth |
Quantitative easing and forex markets
QE can have a direct impact on currency markets.
- Follow announcements: central bank speeches and press conferences about QE often trigger sharp currency moves.
- Manage volatility: use stop-loss orders and sensible position sizes to handle sudden FX swings. Trading CFDs involves significant risk of loss.*
- Diversify: holding a mix of currency pairs and asset classes can help balance risk when QE shifts FX markets.
- Currency effects: QE usually weakens a currency by increasing supply. This makes exports more competitive but raises import costs.
- Winners and losers: exporters often benefit from a weaker currency, while importers face higher costs.
*Stop-loss orders are not guaranteed. Guaranteed stop-loss orders (GSLOs) incur a fee if activated. CFDs are traded on margin, and leverage amplifies both your losses and your gains.
Past performance is not a reliable indicator of future results.