What’s Up? Quantitative Easing and Inflation by Research Affiliates

In a recent piece from Research Affiliates, Chris Brightman, chief investment officer, provides “Central Banking 101,” noting that just within the last several months the Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates, Japan has embarked on an even more aggressive program of QE and the European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?”

It’s no wonder investors are perplexed. QE’s direct and indirect effects are complex, and the fact that various polities are at different stages of implementation doesn’t make it any easier to understand the dynamics. In the piece, Chris tries to explain QE in plain language, why central banks have adopted it, and how it can affect inflation and security prices. He also comments on what’s happening now. 

What’s Up? Quantitative Easing and Inflation

The Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates. Japan has embarked on an even more aggressive program of QE. The European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?”

It’s no wonder investors are perplexed. quantitative easing’s direct and indirect effects are complex, and the fact that various polities are at different stages of implementation doesn’t make it any easier to understand the dynamics. I don’t have all the answers, but I will try to explain quantitative easing in plain language, why central banks have adopted it, and how it can affect inflation and security prices. I’ll also comment on what’s happening now.

Central Banking 101

In the normal functioning of a fractional reserve banking system (McLeay et al., 2014), commercial banks create money when they take deposits and make loans. Central banks limit the amount of money that commercial banks can create by managing reserve requirements. They provide liquidity to the banking system by lending directly to banks through the discount window. Central banks also influence interest rates and the pace of money creation by buying and selling securities through open market operations.

The primary objective and typical standard of success for central banks is stable prices. Price stability no longer means zero inflation; it is seen as a low and steady inflation rate, along with stable expectations of future inflation. For small countries with large trade sectors, the foreign exchange value of the currency may be a better measure of price stability. In the extreme, small countries sometimes choose to adopt exchange-rate stability as a primary objective and peg their currency to a larger global currency, such as the U.S. dollar or euro.

Executing monetary policy becomes trickier with additional objectives. The Fed, unlike other central banks, has a dual mandate of maintaining stable prices and fostering maximum employment. All central banks share financial market stability as an objective. Perhaps the most important function of a central bank is lender of last resort.

Quantitative Easing

QE is a policy consisting of large, sustained, and publicly announced programs of open market operations (The Economist, 2014). Quantitative easing is not money creation; it’s more accurately described as reserve creation. A central bank buys securities and pays for them with bank reserves (liabilities of the central bank and assets of commercial banks), thereby increasing the central bank’s balance sheet and the reserves of its member banks.

See full online at: “What’s Up? Quantitative Easing and Inflation

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Research Affiliates: What's Up? Quantitative Easing and Inflation