Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Quantitative Easing for Crisis Response
Transcript
- Lucas: So we've talked a lot about the standard tools central banks use — open market operations, standing facilities, reserve requirements. But there's one tool that became the headline act after 2008, and it's still controversial today: quantitative easing. Luna: QE. The policy everyone's heard of but not everyone understands. So where do we start? Lucas: Let's start with the problem QE solves. When a central bank cuts its policy rate to zero — or close to it — and the economy still needs stimulus, it can't cut further. That's the zero lower bound. So the Fed, starting in late 2008, turned to buying longer-term securities — Treasury bonds and mortgage-backed securities — on a massive scale. Luna: And the goal there is to push down long-term interest rates, right? Not the overnight rate, but the rates that matter for mortgages and corporate borrowing. Lucas: Exactly. The mechanism is straightforward in theory: the Fed creates bank reserves to buy these bonds, which increases demand for them, which drives up their price and pushes down their yield. That lower yield then spreads to other long-term rates across the economy. The Fed's first QE round, announced in November 2008, involved buying $600 billion in agency debt and MBS. Luna: And that was just the beginning. By the end of QE3 in 2014, the Fed's balance sheet had grown from under $1 trillion to about $4.5 trillion. Lucas: Right. And that number — $4.5 trillion — is a concrete way to grasp the scale. But there's a common misconception that QE is just 'printing money' that will inevitably cause inflation. In practice, the reserves created stay parked at the central bank as excess reserves, especially when banks are cautious about lending. So the money doesn't necessarily circulate in the real economy. Luna: That's the famous 'pushing on a string' problem. But not all QE is created equal. The European Central Bank, for instance, bought corporate bonds too, not just government debt. How does that change things? Lucas: It changes the transmission channel. When the ECB buys corporate bonds, it directly lowers funding costs for companies. The Fed mostly stuck with Treasuries and agency MBS, which works more indirectly through the broader financial system. The Bank of Japan went even further, buying ETFs and even stocks — though that's a different conversation. Lucas: But here's the thing — QE doesn't always work the same way twice. The impact depends on market conditions. In 2008, markets were frozen, and QE helped restore liquidity. In later rounds, the effects were more about signalling and portfolio rebalancing. Luna: And then there's the exit problem. Once you've loaded up on bonds, you have to eventually sell them or let them roll off. That's quantitative tightening, or QT. And that can be just as disruptive. Lucas: We've seen that play out. The 'taper tantrum' in 2013, when then-Chair Ben Bernanke merely hinted at reducing purchases, caused a sharp sell-off in bonds. And the Fed's QT from 2017 to 2019 led to repo market stress in September 2019, when overnight lending rates spiked. So unwinding QE is a delicate art. Luna: It really makes you appreciate the complexity of what central banks are doing. And I think that's part of why we do this show — to make sense of these tools in plain language. Lucas: Absolutely. And speaking of that — we deliberately keep this show free of ads, because we think understanding monetary policy shouldn't require a paywall or a commercial break. If you find this kind of breakdown useful and want to support keeping it that way, you can find us at buy me a coffee dot com slash fexingo. It's a simple way to help us keep going. Luna: Yeah, even a small contribution goes a long way. And it helps us stay independent and focused on the substance. Lucas: So back to QE — one interesting nuance is that the Fed actually uses interest on excess reserves, or IOER, as a tool to control the floor of the fed funds rate. When they created all those reserves through QE, they needed IOER to keep the fed funds rate from dropping below target. So the two tools work together. Luna: Right, because if banks have trillions in excess reserves, they'd be willing to lend them at very low rates in the fed funds market. IOER sets a floor by giving banks a risk-free return on those reserves. Lucas: Exactly. So QE and IOER are a package deal. And that's why the Fed's balance sheet is still elevated today, even after some QT. As of mid-2026, it's still above $7 trillion, partly because reserves are needed to implement the floor system. Luna: Let's talk about a specific episode that illustrates the risks. The Bank of Japan's QE program has been running for decades now, and they've tried yield curve control — capping the 10-year government bond yield. What happened there? Lucas: The BOJ's yield curve control, introduced in 2016, aimed to keep the 10-year yield around zero percent. But when global inflation picked up in 2022-2023, market pressure to raise yields became intense. The BOJ had to buy massive amounts of bonds to defend the cap, which distorted markets and led to criticism. Eventually they had to widen the band and then abandon the cap in 2024. Luna: So even a central bank as powerful as the BOJ can't hold back market forces forever. That's a lesson for all of them. Lucas: It really is. And it highlights a broader point: QE is not a magic wand. It works best in specific conditions — when markets are dysfunctional or when the private sector is deleveraging. In normal times, its effects are more muted. Luna: And there's also the distributional impact. QE tends to boost asset prices, which benefits wealthier households who own stocks and bonds. That's a criticism that's hard to dismiss. Lucas: No question. The Fed's own research has acknowledged that QE can widen wealth inequality. That's part of why the policy is so debated — it's not just about aggregate demand; it's about who gains and who loses. Luna: So where does that leave us today? Most major central banks have used QE extensively, and they're still figuring out how to normalize. What's the current thinking? Lucas: The consensus is that QE will remain in the toolkit for crisis use, but central banks are more cautious about the scale and duration. The Fed, for example, has signaled that in future crises, they might use a standing repo facility or other tools before resorting to large-scale asset purchases. And they're also developing a clearer framework for when to start QT. Luna: So the takeaway is that QE is a powerful but imperfect tool — one that requires careful calibration and a clear exit strategy. Lucas: Exactly. And as we've seen, even the best-laid plans can go awry when markets test your commitment. That's the reality of modern central banking.