Monetary easing refers to actions taken by central banks to stimulate economic growth by increasing the money supply and reducing interest rates.

It is typically implemented during economic downturns, recessions, or periods of deflation to encourage borrowing, spending, and investment.

Common monetary easing methods include lowering key interest rates, purchasing government securities (quantitative easing), and reducing reserve requirements for commercial banks.

Monetary easing is part of an expansionary monetary policy.

Most central banks alternate between policies of monetary easing and monetary tightening to encourage growth while keeping inflation under control.

What is monetary easing?

Monetary easing refers to actions undertaken by a central bank to stimulate economic activity by expanding the money supply. This is typically achieved through measures such as lowering interest rates or purchasing assets.

By lowering interest rates, central banks aim to reduce the cost of borrowing for businesses and consumers, thereby encouraging investment and spending. This, in turn, can lead to increased economic activity and employment2.

The Federal Reserve (also known as the Fed), the central bank of the United States, uses monetary easing to achieve its dual mandate of promoting maximum employment and stable prices.

Monetary easing can be used as a countercyclical tool to counteract economic downturns5. For example, during a recession, the Fed may lower interest rates to encourage spending and investment, helping to stabilize the economy and prevent a deeper downturn.

The European Central Bank (ECB) also utilizes monetary easing to influence bank lending and risk-taking3. However, in a low-interest-rate environment, the ECB faces challenges in stimulating lending while mitigating risks.

The effectiveness of monetary easing depends on the ability of banks to raise external financing. When interest rates are low, easing monetary policy may have a reduced impact on bank lending and could potentially induce banks to take on more risk.

It is important to note that the Fed’s approach to inflation targeting has evolved over time, with policymakers continuously learning and adapting their strategies6. This highlights the dynamic nature of monetary policy and the need for central banks to remain flexible in their approach to monetary easing.

Another important aspect of monetary policy is the “time inconsistency problem.” This refers to the temptation for policymakers to deviate from their stated inflation targets in the short term to achieve other objectives, such as boosting employment.

However, such deviations can undermine the credibility of the central bank and lead to higher inflation expectations in the long run. To address this problem, many countries have granted their central banks independence from political influence, allowing them to focus on maintaining price stability.

What are historical examples of monetary easing?

Monetary easing has been implemented by central banks in various countries throughout history, often in response to economic crises or periods of slow growth. Here are some notable examples:

United States: The Federal Reserve has employed monetary easing measures on several occasions to address economic challenges. For instance, during the 1984-1986 period, the Fed gradually eased monetary policy in response to a slowdown in economic growth and favorable inflation readings. Similarly, in 1995-1996, modest easing was implemented to address moderating growth and receding inflationary pressures. In the early 1980s, the Fed faced a more challenging situation with high unemployment and weakening growth but still pursued easing to bring down inflation.

Japan: The Bank of Japan has a long history of using monetary easing, particularly in its efforts to combat deflation. In 1999, the Bank of Japan introduced negative interest rates, and later, from 2001 to 2006, implemented quantitative easing (QE) by purchasing government bonds to increase the money supply. Following the Great Recession, the Bank of Japan continued its efforts with more aggressive QE programs and maintained its negative interest rate policy until 2025.

Australia: The Reserve Bank of Australia has also used monetary easing to stimulate economic growth and reduce unemployment. In 1996-1999, the central bank eased policy to support stronger growth and address relatively high unemployment6. Earlier, in 1977-1979, easing was employed amid decelerating inflation and softening growth.

Europe: The European Central Bank adopted QE policies after the 2007-2008 financial crisis to support the struggling Eurozone economy. In 2014, the ECB became the first major central bank to implement negative interest rates as a further measure to stimulate economic activity.

United Kingdom: The Bank of England also turned to QE as an additional monetary policy tool during the 2007-2008 financial crisis to alleviate the economic downturn and support financial stability.

In addition to these specific examples, central banks worldwide implemented monetary easing measures in response to the COVID-19 pandemic. These actions included interest rate cuts, asset purchases, and other measures to provide liquidity to markets and maintain the flow of credit during a period of significant economic disruption.

What are the tools for implementing monetary easing?

Central banks have a variety of tools at their disposal to implement monetary easing. These tools are often used in combination to achieve the desired effect on the economy.

Interest Rate Adjustments: One of the primary tools of monetary easing is adjusting the policy interest rate. This is the rate at which commercial banks can borrow from the central bank. Lowering the policy interest rate reduces the cost of borrowing for banks, which they can then pass on to businesses and consumers in the form of lower lending rates. This encourages borrowing and spending, stimulating economic activity.

Open Market Operations: Central banks can also influence the money supply through open market operations (OMO). This involves buying or selling government securities in the open market. When a central bank buys government securities, it injects liquidity into the financial system, increasing the money supply and lowering interest rates.

Quantitative Easing (QE): When interest rates are already near zero, central banks may resort to quantitative easing (QE). This involves large-scale asset purchases, such as government bonds or other securities, to further reduce long-term interest rates and inject liquidity into the economy. QE can also influence market expectations by signaling the central bank’s commitment to supporting the economy.

Reserve Requirement Adjustments: Central banks can adjust the reserve requirements for commercial banks. This refers to the amount of funds that banks must hold in reserve against their deposits. Lowering reserve requirements frees up more funds for banks to lend, increasing the money supply.

Discount Rate Policies: The discount rate is the interest rate at which commercial banks can borrow directly from the central bank. Lowering the discount rate can encourage banks to borrow more, increasing their lending capacity and stimulating economic activity.

Forward Guidance: Central banks also use forward guidance to communicate their intentions regarding future monetary policy. This can help shape market expectations and influence interest rates and investment decisions. By providing clear guidance on the future path of monetary policy, central banks can reduce uncertainty and promote stability in financial markets.

What are the potential benefits and drawbacks of monetary easing?

Monetary easing can be a powerful tool for stimulating economic activity and achieving price stability, but it also carries potential risks and limitations.

Potential Benefits:

  • Stimulating Economic Growth: By lowering interest rates and increasing the money supply, monetary easing can encourage borrowing, investment, and spending, leading to increased economic activity and potentially higher GDP growth.
  • Combating Deflation: Monetary easing can help prevent deflation, a sustained decrease in the general price level, which can be detrimental to economic growth. By increasing the money supply, central banks can help to keep inflation at a healthy level.
  • Supporting Employment: Increased economic activity generated by monetary easing can lead to job creation and reduced unemployment. This can have positive social and economic benefits, as higher employment levels contribute to increased incomes and improved living standards.
  • Boosting Asset Prices: QE can lead to higher asset prices, such as stocks and bonds. This can increase wealth for those who hold these assets, potentially leading to increased spending and further economic stimulus.

Potential Drawbacks:

  • Inflation Risk: One of the main risks of monetary easing is the potential for inflation. Increasing the money supply without a corresponding increase in the production of goods and services can lead to higher prices. Central banks need to carefully manage this risk to avoid runaway inflation.
  • Stagflation Risk: In some cases, monetary easing may not be effective in stimulating economic growth and could potentially lead to stagflation, a situation with high inflation and low growth. This can be a particularly challenging economic environment to manage.
  • Currency Devaluation: Increased money supply can devalue the domestic currency/ While this can make exports more competitive, it also makes imports more expensive, potentially leading to higher inflation.
  • Limited Lending: While QE increases liquidity for banks, it doesn’t guarantee increased lending or investment by businesses and individuals. Banks may be hesitant to lend if they perceive the economic outlook to be uncertain, even with increased liquidity.
  • Exacerbating Inequality: Monetary easing can disproportionately benefit those with assets and access to credit, potentially widening wealth disparities.  This is because lower interest rates and higher asset prices tend to benefit those who already have wealth, while those without assets may not see the same benefits.
  • Financial Imbalances: Prolonged periods of monetary easing can contribute to financial imbalances, such as asset bubbles and excessive risk-taking. This is because low interest rates can encourage investors to search for higher yields, potentially leading to overvaluation of assets and increased vulnerability to financial shocks.

To mitigate these risks, central banks often use macroprudential policies in conjunction with monetary easing. Macroprudential policies aim to strengthen the resilience of the financial system and mitigate systemic risks by addressing vulnerabilities that could amplify economic shocks.

What’s the impact of monetary easing?

Monetary easing can have varying effects on different sectors of the economy and different groups of people.

Sectors:

Sector Impact of Monetary Easing
Financial Sector Can impact bank lending, risk-taking, and profitability.
Housing Market Lower interest rates can stimulate demand for mortgages and increase housing prices.
Export Sector Currency devaluation can make exports more competitive in international markets.
Import Sector Devalued currency can increase the cost of imports.

Groups:

Group Impact of Monetary Easing
Borrowers Benefit from lower interest rates on loans.
Savers May experience lower returns on their savings due to lower interest rates.
Investors Can benefit from higher asset prices.
Low-Income Workers Can benefit from increased economic activity and reduced unemployment.

The distributional effects of monetary easing can be complex and depend on various factors, including the specific policies implemented and the overall economic context. For example, in countries with higher levels of financial inclusion, poor households may have easier access to credit and benefit more from lower interest rates.

Furthermore, the impact of monetary easing can be heterogeneous across households depending on their indebtedness and asset ownership20. For example, a reduction in policy rates will decrease interest payments for households with outstanding debt, but it will also reduce interest income for households holding financial assets.

Monetary policy can have both direct and indirect effects on households. Direct effects include changes in households’ incentives to save and their net financial income. Indirect effects work through changes in aggregate demand, which affect employment and wages.

While direct effects can be heterogeneous, indirect effects tend to be beneficial for all households as they lead to higher wage income.

Why should currency traders care about monetary easing?

Monetary easing is of significant importance to currency traders because it can have a substantial impact on exchange rates.

When a central bank engages in QE, it typically leads to a depreciation of the domestic currency. This is because lower interest rates make the domestic currency less attractive to foreign investors seeking higher returns, leading to capital outflows and a weaker currency.

The impact of monetary easing on exchange rates can be further influenced by a country’s exchange rate regime. Countries with fixed exchange rates have less flexibility in their monetary policy, as they need to maintain the value of their currency against a specific target.

In contrast, countries with flexible exchange rates have more freedom to use monetary easing to stimulate their economies, as their currencies can adjust freely in response to changes in monetary policy.

Monetary easing can also affect other financial markets, such as bonds and commodities. QE can lower bond yields by increasing the demand for government bonds.

This can also have an indirect impact on commodities markets, as lower interest rates can make it cheaper for businesses to finance inventories, potentially leading to increased demand for commodities.

Currency traders need to closely monitor monetary policy announcements and actions by central banks to anticipate potential impacts on exchange rates and other financial markets.