QE and the Inflation and Exchange Rate Myths

What is quantitative easing?

• Short-term central bank interventions in markets are probably not QE, even if they involve large-scale buying of assets
• But, if the buying is persistent, and is intended for a stated macroeconomic purpose, such as holding an exchange rate peg or meeting an inflation target, then it could be QE

What was the myth surrounding QE and inflation?

Many people feared that additional money created by QE would cause runaway inflation. Some economists warned that high levels of bank reserves due to QE would flow out into the economy via excessive bank lending, triggering high inflationary pressures. Hence, each time the Federal Reserve announced a new round of QE, inflation fears actually raised the yields on government bonds.

However, we now know that QE doesn’t significantly raise inflation. The ECB’s QE, is successfully depressing yields on Eurozone assets, yet inflation in the Eurozone remains stubbornly below target.

What is the myth regarding exchange rates?

It is believed that QE debases the currency. If the central bank is only buying assets denominated in its own currency, there should be little effect on the exchange rate unless investors are being irrational about inflation. QE simply exchanges one type of dollar for another.

There is a type of QE that specifically affects exchange rates. For example, when a central bank sells its own currency and buys assets denominated in a foreign currency, the exchange falls versus that currency. In fact, central banks often intervene in FX markets, buying and selling their own currencies to smooth out exchange rate fluctuations.

What is the effect of QE on liquidity in the repo market?

Big banks in the USA started to hoard reserves instead of lending them to other banks, hence the repo market became short of liquidity. To bring it down, the Federal Reserve bought large quantities of short-dated government bonds, paying for them with newly created money - in other words, a liquidity injection in the repo market.

QE does have the effect of providing liquidity to the markets, but that’s not really it's purpose. And it does depress interest rates, but it isn’t intended to prevent short-term interest rate spikes.