When Rates Hit Zero
Normally, central banks manage the economy by adjusting interest rates. But what happens when rates are already near zero and the economy is still struggling? Cutting rates further into negative territory has limited effect and creates its own problems. In these situations, central banks turn to an unconventional tool: quantitative easing (QE).
QE involves the central bank creating new money electronically and using it to buy financial assets — typically government bonds and sometimes corporate bonds or mortgage-backed securities — from banks and other financial institutions.
How QE Works
When the central bank buys bonds from a bank, the bank receives cash in exchange. That cash sits in the bank's reserve account. Banks with more reserves are more inclined to lend, and the extra money flowing into financial markets pushes asset prices up and yields down.
Lower yields on government bonds ripple through to lower borrowing costs across the economy. Mortgage rates fall. Corporate borrowing becomes cheaper. This is meant to encourage spending and investment when the economy is weak.
QE also has a "portfolio rebalancing" effect: when investors sell bonds to the central bank, they take the cash and buy other assets — equities, property, corporate bonds — pushing prices up and the overall level of interest rates down.
The Risks and Limits of QE
QE is powerful but not without controversy:
Asset price inflation. By pushing money into financial markets, QE tends to benefit those who already own assets — widening wealth inequality between asset owners and those without.
Inflation risk. If the central bank injects too much money and the economy rebounds sharply, inflation can take off. Reversing QE (called quantitative tightening) requires selling those bonds back — shrinking the money supply — which can itself cause market disruption.
Diminishing returns. Each round of QE tends to have a smaller effect than the last, as markets become accustomed to it.
Why This Matters
QE was used extensively after the 2008 financial crisis and again during the Covid-19 pandemic. Understanding it helps you interpret why asset prices rose sharply during those periods and why central banks subsequently had to fight inflation by reversing course. The money created during QE doesn't disappear instantly — its unwinding shapes market conditions for years.