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Guide to QE: bond purchases can add new money to economy, drive down rates

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FRANKFURT - The European Central Bank has said it could use quantitative easing — the purchase of large amounts of financial assets such as bonds — as a way to boost the struggling economic recovery in the 18-country eurozone.

Such a program has been used in major economies like the U.S., Britain and Japan, but not in the eurozone.

Here are questions and answers on quantitative easing, or QE for short.

Q: What is QE?

A: Typically, it's when a central bank buys bonds from private-sector banks or other financial institutions such as insurance companies. The central bank pays for the bonds by adding newly created money to the reserve accounts that the financial institutions are required to have with the central bank.

Q: How does that help?

A: By purchasing bonds, the central bank drives down market interest rates, making it cheaper for businesses and consumers to borrow. That's because the purchases drive up bond prices, which move in the opposite direction of interest yields. So QE can make credit cheaper and more abundant.

Q: And that's good because...?

A: Credit is a key factor in economic growth. Businesses borrow to expand production. Consumers borrow to buy houses or large items such as cars.

Q: What else can QE do?

A: It can also increase inflation. Right now that's a key goal for the ECB. Inflation in the eurozone is way too low at an annual 0.3 per cent. It's a sign the economy remains weak and makes it harder for governments to shrink their high public debt.

Q: So why don't central banks do QE all the time?

A: Usually central banks steer the economy using their benchmark interest rates. QE is something that's done when interest rates are near zero. The ECB's benchmark rate is now 0.15 per cent. There's not much left to cut.

Q: Can the central bank buy any kind of bonds?

A: In the case of the U.S. Federal Reserve, it was government bonds — Treasurys — and bonds based on mortgages. It's not clear what kind of bonds the ECB would buy: government or corporate. Buying government bonds would open the ECB to criticism that it is propping up the finances of governments and reducing pressure on them to reform.

The ECB has also talked about buying bonds made up of bundles of bank loans to small businesses as a way to stimulate lending. That would be on a smaller scale.

Q: Sometimes QE is called printing money. Why is that?

A: Actually no printing press is involved. The central bank uses its unique powers as the issuer of the currency. The money is created electronically, by increasing the sum in the bank's reserve account. That increases the amount of money in the financial system. If banks lend those funds, that increases the amount of money in the economy.

Q: Is QE effective — does it always increase growth?

A: The effect of QE is difficult to measure. The United States, however, has seen falling unemployment since launching QE in 2009, and Fed Chair Janet Yellen says the program helped.

Michael Koetter, a professor at the Frankfurt School of Finance and Management, says "the jury is still out" on how much the U.S. improvement can be credited to QE. That's because no one knows what would have happened without it.

"My verdict would be, it has at least not done any harm, but also has not caused a big boost to the supply of credit," Koetter said.

The ECB has said QE would be more effective if governments join in by spending more on investment and cutting burdensome regulations on hiring and firing.

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