Understanding quantitative easing

Quantitative easing encourages spending and investment—helping us achieve our inflation target by stabilizing the economy.

Another tool for inflation targeting

The Bank of Canada adjusts 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 an exceptional tool that 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, which helps the economy run smoothly. 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.

QE sends a signal that our policy interest rate will be low for some 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.

In short, quantitative easing helps us achieve our 2 percent inflation target.

Paying with settlement balances, not cash

QE is not the same as printing cash. Under QE, we buy bonds 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 deposit 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. The power to create money should be kept separate from the power to spend money.

How we buy the bonds

When we conduct QE, our bond purchases are a monetary policy tool used to supplement changes to our policy interest rate.

Here’s how it works:

1. 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.)
2. To pay for the bonds, we create settlement balances and deposit them into the accounts that financial institutions have at the Bank of Canada.

In normal times, when we purchase bonds or other financial assets, it is to offset the liabilities on our balance sheet—the main one being the amount of currency in circulation.

Understanding quantitative tightening

QE is not meant to be permanent. Once the economy is working as it should, we no longer need to hold all the bonds that have been purchased. So over time, we shrink our balance sheet through a process known as quantitative tightening (QT).

QE stimulates the economy by pushing borrowing costs lower when the policy interest rate is already very low. QT undoes the bond purchases made under QE, removing that downward pressure on interest rates and bringing the Bank’s balance sheet back to a more normal size.

QT can be either active or passive. With active QT, bonds are sold. With passive QT, bonds are allowed to mature without being replaced. Both options reduce the amount of settlement balances and shrink the Bank’s balance sheet.