Quantitative Easing

Central bank reserves are swapped for bonds held by the private sector. The size and composition of both balance sheets change; the net wealth of the private sector does not. Read as a swap rather than a gift, most of the confusion disappears.

A swap, described exactly

Quantitative easing is a purchase by the central bank of bonds from the private sector, paid for with newly created bank reserves. The central bank hands over reserves and takes bonds, and the seller hands over bonds and receives reserves. Both sides of the trade are claims, so what moves is the composition of two balance sheets.

What actually changes

The private sector ends with fewer long-dated bonds and more reserves. The central bank ends with more bonds and more reserve liabilities. Neither side is richer in net terms at the moment of the swap: the private sector has exchanged one asset for another, and the interest it used to earn on the bond is replaced by the rate paid on reserves.

Two things do change. The duration of the bonds left in private hands falls, so the private sector bears less interest-rate risk, and the central bank's balance sheet grows. Quantitative easing is therefore best read as a change in the maturity and composition of public and private balance sheets, not as a transfer of wealth.

Using the frame

That is why the effect runs through prices and premia rather than through a cash windfall. By removing long bonds from the market, the central bank compresses the term premium, the extra yield investors demand for holding long paper, and pushes private portfolios into other assets.

One checkable use: when a headline claims the central bank has printed money and given it to the banks, ask what the banks gave up. If reserves were exchanged for bonds, the claim describes a swap, and the private sector's net worth is unchanged at the moment of the trade. Quantitative easing is not net wealth creation.

Related: Money Multiplier · Base Money · Term Premium

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