The transformative power of quantitative easing is well established, but how exactly does it work and why should investors take note?
Dec. 19, 2022
With inflation concerns mounting and all eyes fixed on any potential measures to quell rising costs, there's been a lot of talk about quantitative easing. Is it good? Is it bad? Does it work?
The U.S. Securities and Exchange Committee (SEC) previously announced plans to wind down its cycle of quantitative easing, sending tremors through the investing world late last year. But before we can even attempt to answer any of these queries or examine the SEC's announcement, there's a much bigger question at hand...
What exactly is quantitative easing?
Quantitative easing is a policy used by governments in order to create more available money within the economy. It does this by getting a central bank to purchase predetermined amounts of long-term securities such as bonds or stocks.
The process is typically used to boost spending in an economy following a period of economic turmoil or recession. The injection of cash into the system through bonds serves to lower the bond yield - the number of interest holders of these bonds get.
This lowering of interest ends up feeding back into household and business loans. With interest rates lowers, consumers have more discretionary money to spend which results in a boost for the wider economy. Banks can also lend with easier terms, creating even more available cash.
Why is it important?
Quantitative easing is a very powerful tool for helping economies recover following a crash. It has been used to great effect by almost all major central banks across the world following both the financial crisis of 2008 and the COVID-19 pandemic respectively. Numerous studies have proven the impact it can have on increasing inflation and spending within an economy.
Quantitative easing helps countries keep inflation controlled and stable, allowing appropriate future planning. However, there are cases where quantitative easing can cause excess inflation. Worse still, there are instances where the process can create the necessary inflation but fail to stimulate any economic growth. This is known as stagflation.
How does it affect the stock market?
Currently, the evidence suggests that quantitative easing is directly related to a rising stock market. This makes sense, as an injection of cash into an economy should typically allow for more money to be invested into stocks. Shareholders predict stronger business revenue as a result of the policy and invest accordingly.
It's important to note though that some economists believe that quantitative easing can artificially inflate the prices of some stocks. By lowering interest rates, creating demand for assets, and reducing the individual purchasing power of each unit of money, stocks can become inflated by reactionary trading as opposed to the underlying value of the stock.
Keep this in mind when investing during quantitative easing. Make sure you're not just hopping on a trend and that you truly believe in the value of the company you're staking your money in.
With quantitative easing slowing down as we hope to emerge from the global pandemic, the stock market might end up pulling back in response. If this happens, don't panic. Remember why you invested in your stocks in the first place. Remind yourself that you're in this for the long haul and that long-term investing is one of the best ways to achieve financial freedom.
