Quantitative easing, otherwise referred to as QE or simply asset purchases, is monetary policy aimed at injecting money directly in the economy. This injection would be aimed at encouraging lending and liquidity in response to a significant drop in demand and consequently a situation of insufficient money in the economy.

Despite the possibility of a weaker currency, the biggest risk out of QE is that it may also lead to higher inflation- Rudolf Muscat

With QE, the Central Bank wants to influence the quantity of money in the economy by injecting additional reserves to revive spending. It does so by purchasing financial assets from the private sector from firms like insurance companies, pension firms and commercial banks.

A more conventional way for Central Banks to attempt to increase lending and activity would be by cutting interest rates, but when the rates are at or close to zero, the Central Banks need to look for other less conventional tools like QE – nonetheless the tool is still aimed to achieve the same objectives.

But how does this really work?

The Central Bank will be buying assets using new money created electronically. This Central Bank’s new money, used to buy financial assets from the commercial banks and the other institutions, would then fill these same banks with more liquidity and it is easier for them to lend to the public as well. In short, the ease of borrowing and improved credit should then ideally inspire consumption and investment from consumers and businesses through various channels.

In its quarterly bulletin way back in 2009, the Bank of England outlined three channels.

The first is asset prices and portfolio effects. Asset purchases pushes asset prices higher and increases the wealth of asset holders.

Higher asset prices also lowers yields and, in so doing, makes borrowing costs cheaper. This will continue to trigger a search for higher yielding assets.

In general, portfolios that would have sold an asset to the bank will now require replacing the missing asset with another one from another seller.

The same would also apply to the seller’s portfolio, to create a continued turnover. In turn, lower yields reduce the cost of businesses and households leading to higher consumer spending and investment.

There are also bank lending effects. Asset purchases made as a result of QE leave the commercial banks with higher liquid reserves.

While banks will keep a stock of liquid assets to meet payment demands, if liquidity increases substantially, at some point they should be more willing to do something more productive with it. The banks would probably be more prone to extending loans to their clients and, in turn, these loans will be passed on to households and companies as they are spent.

A third channel is expectations. Asset purchases in themselves represent a significant commitment by the Central Bank to do whatever it takes to meet its targets, particularly its inflation target. This helps harness risk aversion but also helps avert the risk of deflationary pressures and helps keep inflation closer to the target.

Going back to what we termed as ‘new money’ earlier. Another common term is ‘printing money’ when referring to QE. This term, however, usually comes as a form of criticism that throughout the process of QE the Central Bank would actually be financing government debts and deficits – criticism that Central Banks have had to repeatedly defend themselves from.

‘Sterilised’ QE is one of those terms that commonly surfaces in the media. In essence, if we had to see the currency in question as just another product, we could then say that when the Central Bank would be injecting cash (through QE), it would also be boosting the supply of the currency and, hence, one could expect a decrease in the value of that product, or, in our case, the currency. Yet despite the possibility of a weaker currency, the biggest risk out of QE is that it may also lead to higher inflation.

Now a Central Bank promising to sterilise its QE operations is implying that the excess money created will eventually be absorbed from some other part of the system and, in the end, will all be a cash-neutral operation. This would just boil down to money moving around the market from one place to the other.

While many of these tools are relatively new for the Central Banks, many of the possible risks or side effects are often questioned. We have often seen commentators questioning the effectiveness of a second or even a third round of quantitative easing, like we have seen from the US Federal Reserve.

Inflation and default risk are also major concerns. Other factors are questioned as well, such as what will the banks do with the new liquidity boost. Will banks push the money out or are they hoarding the cash reserves and keeping their lending requirements tight?

Why then would the Central Bank inject more liquidity if banks are piling cash? It is hoped that the piling of reserves should, at some point, contribute so much less utility that the bank would be better off engaging those reserves elsewhere.

However, not all the noted side effects have negative connotations. Otherwise, why would the Central Banks embark on it? It has been noted throughout these years that quantitative easing has other positive outcomes, such as boosting of market confidence, stock markets and in turn consumption and it may also reduce systemic risk.

After the Bank of Japan, even the US Federal Reserve, the European Central Bank and the Bank of England have engaged in QE. While the Federal Reserve and the BoE’s programmes were aimed at supporting the money supply, the ECB distinguishes its QE programme with the fact that it sterilises its operations.

Yet the recent Outright Monetary Transactions introduced by the ECB has found observers comparing it to another QE programme as, like QE, OMT tend to push bond yields lower.

How does QE affect you as an investor?

The longer term effects are more indirect than direct, and they should affect the economy as a whole. However, for investors already holding investments there are some short run effects to consider as well.

We have already mentioned the possible effect on the prices of asset in general, but in the immediate term, stock markets tend to be buoyed by expectations ahead of the start or continuation of the announced programme.

In terms of currency exposures, QE tends to be at least a short-term negative, given that the programme in itself is aimed at boosting supply of that Central Bank’s currency – the increased supply will reflect in a weaker currency. Yet the currencies also will strengthen or weaken relative to each other due to interest rate differentials. USD/JPY is a practical example of this.

Rudolf Muscat is a senior trader at RTFX Ltd.