Quantitative easing is a tool that encourages spending and investment—helping us to achieve our inflation target by stabilizing the economy.
A different approach to inflation targeting
At the Bank of Canada, we adjust the policy interest rate to influence economic growth and inflation. If we see that the economy needs a boost to meet our inflation target, we can lower our policy interest rate to encourage borrowing and spending. Changing our policy interest rate directly affects very short-term interest rates. This eventually has an impact on mortgages, lines of credit and other, longer-term interest rates that matter to Canadians.
But when our policy rate is very low, we may need to use other monetary policy tools to support the economy and reach our inflation goal.
One of these tools is quantitative easing (QE). QE is different from our normal policy actions because it allows us to more directly influence those longer-term interest rates that consumers and businesses pay. But the tool has the same objective as changing our policy rate—to achieve our inflation target.
How quantitative easing affects inflation
The goal of our monetary policy is always to reach our inflation target. We use QE to counter the risk of deflation—a dangerous decline in prices that harms everyone. QE helps stabilize the economy by making it easier for Canadians to borrow money and for companies to stay in business, invest and create jobs.
Under QE, a central bank buys government bonds. Buying government bonds raises their price and lowers their return—the rate of interest they pay to bondholders. This rate of return is also known as the bond’s yield.
Government bond yields have a big influence on other borrowing rates. Lower yields make it cheaper to borrow money. So, QE encourages households and businesses to borrow, spend and invest. For example:
- We can buy five-year government bonds, which will lower their yield. This would be reflected in lower interest rates on five-year fixed-rate mortgages, making it cheaper to borrow to buy a house.
- Or, we can buy long-term government bonds, which mature in 10 years or more. In this way, we can make it cheaper for businesses to borrow and grow through long-term investments.
What’s more, QE sends a signal that we intend to keep our policy interest rate low for a long time—as long as inflation stays under control. By giving more certainty that our policy interest rate will remain low, QE can help reduce longer-term borrowing costs for businesses and households.
Paying with settlement balances, not cash
QE is not the same as printing cash. Under QE, we buy bonds in the open market from financial institutions. And the funds that we use to pay for these purchases end up being deposited in accounts that financial institutions have at the Bank in the form of settlement balances.
Settlement balances (or reserves) are a unique type of money that the central bank creates. They are a normal part of central banking operations. Financial institutions use them to settle payments among themselves. We pay interest on these balances, like deposits at a regular bank.
Being able to issue settlement balances is a privilege that only central banks have. We use this ability carefully to fulfill our mandate of promoting Canada’s economic and financial welfare.
It’s important for central banks to be independent from the government. Simply put, the power to create money should be kept separate from the power to spend money.
Where we buy the bonds
As part of our normal operations, we buy bonds directly from the government to help us balance the stock of bank notes that exists on our balance sheet. But under QE, we buy bonds only on the open market. QE doesn’t finance government spending, because we buy bonds that have already been sold by the government to banks and other financial institutions.
Here’s how it works:
- We offer to buy bonds from financial institutions that are willing to sell them to us at the best price. (This is called a reverse auction because we are auctioning to buy—not sell—the bonds.)
- To pay for the bonds, we create settlement balances and deposit them into the accounts that financial institutions have at the Bank of Canada.
Eventually, when the economy has healed enough, we will no longer need to hold the bonds. At that point, we will have options about how to wind up our QE program through a process we call quantitative tightening (QT). For example,
- We could sell the bonds in the open market to financial institutions.
- Or, we could hold onto the bonds until they mature.
Both of these options would reduce the settlement balances in the accounts of financial institutions and shrink the Bank’s balance sheet.
Understanding quantitative tightening
Whereas QE aims to stimulate the economy, the goal of QT is to help pull back that extraordinary support by reversing the purchases.
To that end, QT complements our primary policy tool—the policy interest rate—which influences short-term borrowing costs. QT removes a source of downward pressure on interest rates which isn’t needed when the economy is doing well. This helps bring demand and supply back into balance and inflation back toward the Bank’s 2% target.
Whether a central bank lets its government bonds mature and roll off the balance sheet or whether it actively sells them, under QT the central bank is no longer adding to demand for bonds. As a result, bonds become cheaper and their yields increase. Because other interest rates in the economy are influenced by government bond yields, QT makes borrowing more expensive. Households and businesses therefore borrow and spend less, which eases demand in the economy, helping to soften inflation pressure.
In the same way that QE sends a signal to the public about the Bank’s intention to keep its policy interest rate low for an extended period, QT indicates that interest rates are likely to rise.