Quantitative Easing and Interest Rates

Quantitative Easing (QE) impacts almost every market in the globe. This is because it impacts certain fundamental economic factors which are interconnected across the world. One such factor is interest rates. The policy of Quantitative Easing (QE) is capable of significantly impacting interest rates in various ways. Since interest rates can literally change the market overnight, Quantitative Easing (QE) has the inherent potential to change global markets overnight. In this article, we will look at the short term, medium term and long term impacts of Quantitative Easing (QE).

How Quantitative Easing (QE) and Interest Rates Interact?

Quantitative Easing (QE) has a profound effect on the interest rates that are prevalent in the economy. It may be used by Fed as an alternative to the interest rate policy. However, in the end it ends up influencing the interest rates even more.

The interaction between the Quantitative Easing (QE) policy and the interest rates is said to be fairly simple. At first, the Quantitative Easing (QE) policy leads to a reduction in the interest rates i.e. in the short and medium term, the interest rates go down.

However, in the long term, the interest rates go up significantly. For our purpose, long term may be defined as a period of 5 years or more. This is because Quantitative Easing (QE) is a relatively nascent form of financial policy and its long term effects can only be theoretically calculated. There isn’t much empirical evidence to base the hypotheses on.

The following are the reasons that Quantitative Easing (QE) causes interest rates to drop in the short and medium term and move up in the long term. The first two reasons explain the drop in the interest rates whereas the third reason explains the rise in the interest rates at a later date.

Indirect Signals

Central Banks usually adopt Quantitative Easing (QE) policy only after they have exhausted the other options. This means that Quantitative Easing (QE) is only used when the interest rates are already close to zero and cannot be dropped much further. In such a situation, the market participants have two kinds of anticipations. The first one is that the government will leave the interest rates untouched whereas the other expectation is that the Central Bank may raise the interest rate.

So, when the central bank adopts the policy of Quantitative Easing (QE), they are sending indirect signals to the market that they are still in the expansionary phase. This means that there is almost no chance that they will raise the interest rates in the short term. As a result, the short term interest rates continue to fall further or stay stagnant since there is almost no chance that the central bank may raise it further.

Liquidity Premium

The bonds being sold by the banks and private parties have a liquidity premium attached to their cost. This is because these bonds have an active secondary market wherein they can be liquidated i.e. converted to cash at any given point in time.

The amount of liquidity in these markets depends upon the amount of cash that is available in the system relative to the amount of securities that are present in the market. Hence if there are more bonds in the system and there is less cash to buy them, then there is less liquidity. Hence, the liquidity premium charged will be high. On the other hand, if there is more cash and fewer bonds, the liquidity premium will be less and this lesser premium will reflect in the form of reduced medium term interest rates.

The policy of Quantitative Easing (QE) creates the second scenario i.e. a scenario wherein there are fewer bonds available in the market and more cash. This is because the central bank buys up the bonds and releases cash. Therefore the liquidity premium falls causing a drop in the medium term interest rates.

Inflation Premium

The Quantitative Easing (QE) policy reduces the interest rates in the short and medium term. However, in the long term, it does the exact opposite i.e. it raises the interest rates. This is because the Quantitative Easing (QE) policy is inherently expansionary. An expansionary economic policy if carried out on a longer term basis leads to inflation in the markets. One of the fundamental purposes of the Central Banks is to keep the inflation low. Hence when runaway inflation seems to become prevalent in the marketplace, the central banks are forced to raise the interest rates to bring the prices under control. Thus the expansionary policy in itself brings an end to an extended period of low interest rates.

Therefore, over a period of 5 years or so, the policy of Quantitative Easing (QE) will always cause the interest rates to bounce back higher than they already were.

How Quantitative Easing (QE) Tapering and Interest Rates Interact?

In the above paragraph, we saw how the policy of Quantitative Easing (QE) in itself brings about its end. However, sometimes Central Banks bring about an abrupt termination of the Quantitative Easing (QE) policy with a counter policy known as Quantitative Easing (QE) tapering.

In this case, the interest rates spike almost immediately. The market is in a state of panic because of the sudden shift of policy by the Central Bank from expansion to contraction. This knee jerk reaction causes the markets to shortly stay in a state of disequilibrium wherein the interest rates go sky high before the panic settles and the interest rates return to the normal which is slightly higher than they were during the Quantitative Easing (QE) period.

The policy of Quantitative Easing (QE) therefore has profound impacts on the interest rates. Since interest rates affect almost everything from corporate borrowings to derivative settlements, this policy assumes significance since it can significantly affect the economy.