What Is Quantitative Easing and How Does It Influence Currency Rates?
Author : Andrey Goilov
Dear Clients and Partners,
Quantitative Easing is an instrument used by Central banks to add money directly to the country’s economy. QE does not imply printing a lot of physically existing money, rather, this is a process that creates non-cash funds.
As the next step, the Central bank buys bonds in the private sector. This is also called “buying the government debt”. As a result, the profitability of these bonds decreases, while the overall money supply in the economy grows, in contrast.
The logic is simple: when private companies have more money, they can produce more goods and services. The more services and goods there are in the market, the more money consumers will spend on them, pouring the money into the economy. This is How QE helps the economy develop.
Mind that some analysts under QE mean simple asset buying by the Central bank. Remember here that the goal of QE is to increase spending and investments in the economy by creating non-cash funds.
Let us figure out why Central banks use QE at all, how it works, and how an investor can profit from it.
What is QE necessary for?
Clearly, Central banks do not use this measure all the time. QE is a reply to the economic situation in the country that forms under the influence of global trouble; it can also be solving particular problems. For example, it might be aimed at holding inflation and the growth of prices for goods and servicing at a low and, most importantly, stable level.
Another instrument for reaching such a goal is decreasing the key interest rate in the country’s economy. It also supports the development of the economy in times of global crises or recessions.
Low interest rates let private companies and enterprises get cheap loans, inspiring them to spend the loaned money and invest in the development of their business. For physical persons, this works the same way – in, say, mortgages.
However, there is a certain limit to interest rates, so that they cannot be lower than this level. Hence, Central banks use QE when lowering the rate becomes unreasonable and even harmful.
How does QE work?
The rates of state bonds directly influence other interest rates in the country’s economy. If the CB buys a lot of bonds, the interest rates (profitability) of the latter fall, which, in turn, brings down loan rates. We can conclude that QE makes loans cheaper for the private sector, stimulating their spending.
However, this is not all the potential of this measure: QE can also support the economy by the potential growth of prices for various financial assets.
For example, the Central bank buys bonds for 1 million USD from the pension fund, so the fund gets real money instead of bonds. The fund will hardly just keep in on its accounts; instead, it can invest in various financial instruments such as stocks of large companies that can yield much larger profits. Thanks to this, stock markets also grow: when more investors want to buy certain stocks, the price for the latter ones also grows actively.
Next, we have a more direct correlation: when stock prices grow, the capital of their investors also increases; they now have more money to spend, and their spending stimulates economic activity in the country.
Summing up: buying bonds decreases loan rates and supports the stock market. People and companies have more money to spend and thus spend more, supporting the economy.
However, if the private sector just saves the money it has got from the CB, QE will simply not work.
How does QE influence the currency of the country?
At first glance, QE looks like a perfect way to escape an economic crisis threatening the country. However, it entails several potential risks, one being the weakening of the national currency.
An increase in money supply can lead to the devaluation of the national currency against other world currencies – especially those of such countries where the CB does not carry out QE. Things are again logical: money supply increases noticeably, hence, its price in the world market drops. As a rule, the devaluation happens at the start of QE, while closer to the end of the program, the currency can grow significantly.
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Sincerely,
RoboForex team
