What is quantitative easing and how does it impact markets?

Quantitative easing is a monetary policy tool of central banks, which has received its fair share of criticism for causing inflation. Let’s take a look at the pros and cons of QE and how it can impact the stock market and forex market.

What is quantitative easing?

Quantitative easing (QE) is a type of monetary policy that involves central banks purchasing securities, such as government and corporate bonds, on the open market in order to increase the money supply and spur economic growth.

It’s typically only used when interest rates are near zero and economic growth is stagnant. For example, the Fed used QE measures in 2020 following the financial fallout of the COVID-19 pandemic, growing its balance sheet to $7 trillion worth of bonds and securities.

The aim is to lower the longer-term interest rate, in contrast to changing interest rate policy which only impacts the short-term rate.

Learn about interest rates.

The other aim of QE is to provide liquidity to the entire banking system and financial markets by creating more funds that institutions, traders and consumers can use to borrow, invest and spend.

However, quantitative easing has cons too, which have caused economists to show concern whenever central bans rely on it too heavily. In the short term, it can be hugely effective in stabilising the economy, but it can create inflation, asset bubbles and income inequalities.

How does quantitative easing work?

Quantitative easing works by injecting money into the economy through large-scale asset purchases. Here’s a step by step of how QE works:

1. Central bank buys assets – central banks can print money, creating larger reserves, which can then be used to purchase longer-term bonds from other banks and corporations
2. Money is injected into the economy – as a result of central banks buying securities, other institutions have more capital that can be passed on to consumers, or used to invest in other assets
3. Market liquidity increases – the availability of money means financial services can operate as usual, including the ability to provide loans and borrow money
4. Interest rates decline – banks and other consumers are able to borrow money at cheaper rates, which encourages consumers and businesses to spend money, which boosts economic activity
5. Investors switch to risk-on assets – due to the lower interest rates on savings accounts, investors are able to earn more on higher-returning assets (such as stocks). As a result, companies see stronger gains
6. Consumer confidence returns – central banks have reassured both investors and consumers of their commitment to ensuring economic growth

Does quantitative easing cause inflation?

Quantitative easing can, in theory, cause inflation. As more money enters the economy, the purchasing power of the money already in circulation declines. Businesses are able to raise their prices due to the increase in demand from the growing economy, which, if left unchecked, results in runaway inflation.

Learn about inflation.

However, it’s important to note that QE doesn’t always cause inflation, it just increases the risk of it occurring. For example, when the Federal Reserve introduced QE measures following the 2008 financial crisis, the US economy didn’t experience excessive inflation as a consequence.

How does quantitative easing impact financial markets?

Quantitative easing impacts financial markets because it sends a signal to market participants that central banks are actively buying assets and providing liquidity. It gives investors and traders some security during periods of financial crisis that could otherwise create panic.

Let’s take a look at how quantitative easing impacts two of the most popular financial markets: stocks and forex.

Quantitative easing and stock market performance

Quantitative easing leads to lower interest rates, which typically results in improved share price performance as risk-on assets become more appealing than saving in a bank.

Learn how to trade shares

The lower interest rates also mean that companies can borrow at lower costs, which creates the perfect environment to borrow money to expand the business. The positive sentiment towards companies can attract inflows of short-term financial capital, from both domestic and foreign investors.

However, quantitative easing can cause asset bubbles as a result of the euphoria and confidence created in financial markets. And unfortunately, bubbles can bust, so it’s vital to have suitable risk management measures in place.

Learn about stock market bubbles

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Quantitative easing and exchange rates

Increasing monetary supply through quantitative easing keeps the value of the country’s currency low. When a currency is lower than other global currencies, it becomes more attractive to foreign investors because they can get more for their money.

A lower currency also makes exports cheaper, which can have a positive impact on countries that rely on foreign markets. However, imports become more expensive, which can damage net-importing countries.

A devalued currency is also what leads to inflation, as domestic consumer prices rise but each unit of currency doesn’t go as far as it could previously.

When you trade forex pairs, you’re always speculating on the value of two currencies at once – buying one while selling the other. So, for example, if you thought the value of the US dollar was going to decline against the euro due to Fed quantitative easing measures, you would go long on the EUR/USD pair – buying euros while selling dollars.

Learn more about forex trading or open a demo account to practise opening positions in a risk-free environment.