Investor Primer: What Is Quantitative Easing?
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Investor Primer: What Is Quantitative Easing?

It averted financial collapse, and it continues to play an outsized role in investor decisions. Quantitative easing is less arcane than it sounds, and definitely worth understanding.

There is a simple definition and a difficult definition of quantitative easing (QE). Here's the simple one: QE is when central banks buy fixed quantities of bonds from commercial banks. To do this, the central banks create money that previously didn't exist. That money is not in physical bills and coins, but in accounts – similar to yours at your own bank, except at the central bank. And, er, that's it.

The difficult definition might start with the following statement, known as Taylor's Rule:

Taylor's Rule

So, let's stick with the simple one.

An Alternative to Sub-Zero

Easing (expanding) the supply of money is a completely normal part of a central bank's business. So, too, is tightening (contracting). These are central functions of a central bank, which are aimed keeping an economy stable: not too hot, not too cold, keep inflation down, employment up, stock markets buoyant, homeowners happy and so on.

A central bank's biggest tool for economic steering is its own interest rate. A decrease means easing, an increase means tightening. A central bank's second biggest tool is bond trading. Buying means easing, selling means tightening. The pesky problem here is that interest rates can go only so low. So when interest rates already are near bottom, and the economy packs up – as it did in 2008 – the only way to keep on easing is to buy bonds, not at a targeted interest rate but in fixed quantities. Hence the "quantitative" qualifier. The simple definition, as said by Credit Suisse strategist Jonathan Wilmot: "QE is how central banks ease policy when they'd like to set interest at about -3 percent, but recognise that they can go only down to zero."

Brother, Can You Spare a Trillion?

The fixed quantities happen to be huge. Central banks' QE has since 2008 created several trillions of dollars, euro, yen, pounds and kronor that otherwise wouldn't exist. And if they hadn't , Wilmot adds, we'd be engulfed in a worldwide depression. The US Federal Reserve's first round from 2008-10, now dubbed "QE1", prevented "serial bankruptcies, a massive debt spiral and a general collapse of the economy as we know it." It would have been the 1930s and the 1890s all over again, except it wasn't. Subsequent QE rounds in America, Japan, the UK, the euro zone and Sweden were probably less mission critical. Still, Wilmot and many other experts believe that, on balance, QE has been a good thing, keeping people in work and the economy on its feet.

Pumping up a Bubble?

Too much of a good thing, contend some economists. Anna Zabrodzka of Moody's Analytics, for instance, argues in a mid-July 2015 commentary that "QE feeds asset bubbles." Particularly house prices in Germany, Norway and the UK, she says, have been overinflated by QE from the European Central Bank. Former US-federal-budget-chief David Stockman goes further than Zabrodzka, calling QE a fraud of "false prices". His difficult definition says that "massive monetization of the public debt results in the systematic repression of the "cap rate" on which the entire financial system functions. And when the cap rate gets artificially pushed down to sub-economic levels…." Er, more simply: QE causes bubbles. However, Wilmot argues this interpretation confuses correlation and causation. There might indeed by bubbles building, and QE is of course for real, but that doesn't mean one caused the other.

Rise of "Parity Risk" Portfolios

Not that QE is all roses, Wilmot adds. One of its unintended consequences has been to encourage a portfolio management approach known as "risk parity". A simple definition comes from Jennifer Bollen, writing in "Investment & Pensions Europe". Risk parity, she notes, uses leverage not to increase returns but to reduce risk. This is practiced within a broad portfolio, encompassing stocks, bonds of various types, securitised mortgages, commodities and real estate. Wilmot notes that risk parity investors and a related strategy called volatility controlled equity might have triggered the turbulence that rocked equity markets from mid-August to mid-September 2015. Risk parity players were forced to deleverage – to sell – which knocked equities into a 7 percent tailspin, according to the global index MSCI ACWI. Ironically, the strategy to reduce risk for the few, when practiced by many, ends up increasing risk.

The Losers – Future Generations

The people most penalised by QE are simple to define. Voices ranging from the International Monetary Fund to the European Central Bank (ECB) to the developed-country think-tank OECD have warned that easing and easy money threaten pension funds and insurers. And while indeed they should worry, their future customers should worry even more. Consider the case of a soon-to-retire British national who has paid into a "defined contribution" pension (as opposed to one set by the pensioner's pre-retirement salary). If he takes the standard path of converting his retirement hoard into a fixed-sum annuity, at best he will receive only about one-third the yield that would have been paid out on an identical sum 25-30 years ago. Thanks to QE easy money (and record-low interest rates), the painful truth is that many soon-to-be seniors will need to work longer and live lower-on-the-hog than planned, even if they calculated carefully.

How Long Will QE Last

America's program has already tapered to its finish, and though the ECB's program continues, mainstream opinion is that QE will ease out over the next year. That does not mean, however, that central banks will have recovered completely from the shock of 2008 and its aftermath. It will take even longer, Wilmot says, for spooked banks and markets to recover their "animal spirits". Those were defined by economist John Maynard Keynes, who in 1936 wrote that "our decisions to do something positive…can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." If that definition is too difficult, put it this way: fear and greed, or caution and confidence, drive markets. Wilmot reckons the USA will in time lead a slow recovery of confidence, with interest rates potentially reaching 3-4 percent by 2018.