Quantitative Easing (QE): what it is, how it works and how it affects your investments

Have you been wondering over the past few years why stock prices reached unprecedented peaks or why your mortgage interest rates stayed close to zero for years? Or, conversely, why the fastest inflation in 40 years was so sudden and aggressive? Behind these phenomena often lies one of the most powerful yet controversial tools of modern monetary policy: Quantitative Easing (QE)..

Quantitative easing is not just a technical economic term. It is an instrument that has changed the fundamentals of financial markets and influenced everyone's investment strategy. As this policy is closely linked to the activities of the European Central Bank (ECB), understanding it is crucial for European investors. In this article, we explain the QE mechanism, look at its controversial history in the euro area and analyse what it means for your personal finances.

QE - The cornerstone of unconventional monetary policy

Quantitative relaxation is a non-traditional monetary policy, which central banks implement when conventional instruments (short-term money market interest rates setting) are no longer effective - for example, in a situation where interest rates are already close to zero and the economy still needs a stimulus.

Definition and mechanism of QE

In simple terms, QE is a central bank's large-scale asset purchase programme, where banks buy financial assets from commercial banks and other financial institutions. bonds (mainly government, but also business).

How does it work?

Creating money: A central bank (e.g. the ECB) electronically creates new reserve money for the assets it buys. This does not involve printing paper money, but rather adding numbers to the bank's balance sheet.
Injecting liquidity: This new money will be transferred directly to the accounts of commercial banks, increasing their free reserves, i.e. market liquidity.
Lowering production: As the central bank is a massive buyer, the demand for bonds increases, which in turn pushes up their price and brings down their value. returns (interest rate). This has an indirect impact on long-term market interest rates.
Transmission mechanism: Lower interest rates should motivate banks to lend more money to the real economy and businesses and consumers to spend and invest more, ultimately leading to. inflation to the target set by the central bank (level for the ECB).

Difference from conventional monetary policy

Normal monetary policy involves targeting short-term borrowing rates. The central bank says at what interest rate banks should lend money to each other. QE, on the other hand, goes straight to the long-term bond markets and deals directly with the amount of money in circulation. amount of money.

While the conventional wisdom is to regulate the "throttle" (interest rate), QE is more about "engine capacity" (money supply). ad hoc scaling up in crisis situations.

Case study: quantitative easing at the European Central Bank (ECB)

The ECB has used quantitative easing in two main periods and for two main purposes, both of which have been crucial for Europe.

First wave: the risk of deflation (2015-2018)

In the aftermath of the euro area debt crisis and the global financial crisis, the ECB faced persistently low inflation and deflationary risks. In early 2015, the Expanded Asset Purchase Programme (EAPP) APP)to bring inflation back to close to 2%.

The ECB bought huge volumes of euro area government bonds. This was critical as it kept down the borrowing costs of countries, especially in southern Europe (e.g. Italy and Spain), avoiding a new debt crisis and the risk of a eurozone break-up. Here, QE also functioned as an "indirect lifeline" to the periphery of the euro area.

Second Wave: COVID-19 and PEPP (2020)

When the corona pandemic broke out in the spring of 2020, financial markets panicked and a liquidity crisis ensued. The ECB reacted immediately by launching The Pandemic Emergency Purchase Programme (PEP) (or PEPP). This programme was even more flexible and comprehensive than its predecessors.

The PEPP was designed to ensure that credit conditions would not be tightened in the wake of a sudden economic shock and that governments would be able to finance their large aid packages (unemployment benefits, business support). In short, it was an economic lifesaving mission that saved the economy from an even deeper and potentially catastrophic downturn.

Criticism: controversial double-edged sword

Although QE achieved its primary objectives (avoiding deflation and stabilising the market), there has been a huge amount of criticism:

Asset Price Inflation: At a time when consumer prices remained low, QE directly inflated shares, bonds and, in particular, real estate. Hindus. The wealthier who owned assets got richer, while savers and first-time buyers were left behind. This exacerbated inequality.
Supporting "zombie companies": Low interest rates also kept afloat companies that would have gone bankrupt under normal market conditions. This discourages productivity and innovation.
Addiction: The economy and the banks became overly dependent on central bank support, making interest rate normalisation politically and economically extremely painful.

Direct impact of quantitative easing on private investment

The central bank's action is "upstairs", but its effects trickle down the economic chain and affect every European's money.

Price of Loans and Real Estate

The main aim of QE is to lower long-term interest rates. This meant directly:

Cheap housing loans: Euribor (and hence mortgage interest rates) remained close to zero for many years. This made borrowing exceptionally cheap.
The property market is heating up: Together with cheap borrowing, there was a huge demand for property, which pushed up prices. QE was indirectly one of the important catalysts for the property booms in Estonia and other European countries.

TINA-Effect and stock markets

Under QE, the return on traditional savings was non-existent. Deposits yielded 0% and high quality government bonds offered negative returns. This led to the so-called TINA effect (There Is No Alternative): money had to go elsewhere to earn a return.

Capital invested in shares: Investors, both large and small pension funds as well as individuals, shifted money into riskier assets, mainly the stock market. This kept stock prices higher than they would have been in a normal interest rate environment.
Change in value investment: Cheap credit provided particularly strong support to technology companies with high growth potential (but no profits), as their future profits were discounted at lower interest rates.

Realisation of inflation risk

Although central banks long argued that QE would not lead to inflation, the sharp rise in prices in 2021-2022 showed that the huge increase in the money supply (in addition to supply chain problems and the energy crisis) was the catalyst. This was the biggest risk associated with QE that materialised.

Decreasing value of savings: High inflation erodes the value of savings and low-yielding assets faster than any other factor.

A practical example: In 2014, the ECB bought billions in Italian bonds, keeping their yields low. This allowed the Italian government to borrow cheaply. At the same time, the return on your euro savings was also squeezed, forcing you to choose between accepting zero interest rates or investing in riskier funds or equities. This shows a direct transfer mechanism from the national level to the personal finance level.

Exit: Quantitative Tension (QT) and the future

If QE is pedal stomping, the subsequent process is. Quantitative Tightening (QT) - a reduction in the money supply and balance sheet by the central bank.

How the ECB "Exits" QE

After an unexpectedly rapid rise in inflation, the ECB was forced to normalise its monetary policy. This is happening in two main ways:

Raising interest rates: The ECB raised base interest rates to curb inflation and curb lending.
Launch QT: The ECB has started to reduce its balance sheet. This means that the proceeds of maturing bonds will no longer be fully reinvested in new bonds. Market liquidity will fall and long-term interest rates will start to rise again.

Challenges for Investors During QT

The QT and the rise in interest rates mean a complete change in the investment environment:

Bond resurgence: Fixed income assets (bonds and deposits) are again offering positive returns in real terms. This provides an alternative to stock markets.
Share price correction: Asset prices are correcting due to lower liquidity and higher discount rates. Firms with high debt burdens that relied on cheap money during QE are under particular pressure.
Slowing economic growth: Rising interest rates make borrowing more expensive, holding back the economy and increasing the risk of recession.

To sum up: QE is a giant experiment whose long-term consequences are still being studied. It is an instrument that helped to avoid crises in the euro area, but it also had unintended consequences in terms of distorted asset prices and subsequent inflation.

Summary

For the investor, understanding QE and QT cycles is crucial. Today's financial markets are no longer the result of a purely "free market" but are closely linked to the policy decisions of central banks.

What you should remember:

Monitoring liquidity: QE meant an increase in liquidity, which supported all asset classes. QT means the opposite. Be prepared for an increase in volatility and a possible fall in asset prices as "cheap money" leaves the market.
Diversification (Diversification): After years of equity dominance, fixed income assets (high quality bonds) can again offer attractive returns. A balanced portfolio is a hedge against both inflation and recession.
Prioritising productivity: In today's higher interest rate environment, the most valuable companies are those that can make real profits and have strong balance sheets, not just fast growth.

Quantitative relaxation is not magic, but a sophisticated, risky and profound manipulation of the monetary system. By understanding its principles, you'll be better equipped to protect your wealth and find new opportunities in the fast-changing investment world.