Quantitative Easing: Another Weapon For Central Banks​

By Jake Rickman​

What do you need to know this week?

Over much of 2022, central banks, including the Bank of England, the Federal Reserve, and the European Central Bank, have shifted away from a decades-long practise of “quantitative easing” (QE) and towards “quantitative tightening”.

Why is this important for your interviews?

As national economies continue to slow and inflation persists, you may find it helpful to understand what quantitative easing versus tightening is and what effect it has on markets.

When we talk of central bank policies, especially related to inflation-fighting, we tend to think of their ability to adjust interest rates, especially as of late. This is because the ability of central banks to raise or lower interest rates can either encourage borrowing (through lower interest rates) or slow borrowing (higher interest rates).

However, since 2008, economists and central bankers have developed another tool to influence markets: quantitative easing. This refers to central banks actively buying debt (corporate and government bonds) from other market players (banks and other lenders and large asset managers like pension funds). This frees up lenders’ balance sheets. Because banks can only lend so much at once, by doing so, lenders can simply lend more money.

This tactic emerged following the 2007-08 Global Financial Crisis. Central banks feared that slashing interest rates alone was not sufficient to help the economy grow. By actively buying up bonds, lenders had more cash to loan back out. Following the first wave of lockdowns, central banks doubled down on the practice (in tandem with rate slashes) to stave off a recession.

However, as inflation has soared in recent months, central banks have reversed this policy in what they call “quantitative tightening”. As with rate hikes, the intent is to slow market activity.

The immediate risk is that tightened liquidity will result in a recession, as lenders revise their lending policies, companies borrow less, and consumers become thriftier. But a deeper question is how this may change investment strategies in the long term.

Under their QE policies, central banks generally only purchased relatively safe debt, such as government and local bonds and corporate debt with strong credit scores. This meant that large investors such as pension and insurance funds were pushed into riskier debt to maintain the same level of return on their investments.

The cumulative effect is that the bond market overvalued most debt assets because investors were confident that central banks would always be willing buyers if they needed to offload a particular piece of debt in the future. As the Financial Times notes, investors are not sure what will happen now that we enter a new era of quantitative tightening.

Why is this important for your interviews?

Markets do not like uncertainty. From a medium to long-term perspective, concerns about how the market will respond to quantitative tightening is a massive question mark lurking over the heads of clients. Lawyers need to have a fundamental grasp of the stakes and factor this in when advising their clients.