Why QE Can Lose Effectiveness After Short Rates Reach Zero
Summary
The document explains why near-zero short-term rates are usually a reason to begin quantitative easing, rather than a reason QE stops working. In the account presented, rate cuts first make cash funding cheaper and holding cash less attractive. Once short rates cannot fall much further, central bank bond purchases can push down longer-term yields and encourage investors to shift toward riskier assets. Higher asset prices may support wealth and borrowing conditions and help restore market activity.
QE’s effectiveness may fade later, when purchases have already lifted risky asset prices and reduced their expected returns relative to cash. At that point, further purchases may have less power to encourage risk-taking or create additional wealth effects. The document also includes a separate argument that very low rates can prompt households with long-term savings goals to save more, potentially weakening spending and output. These are explanatory narratives in short answers, not empirical tests; the discussion does not quantify effects or establish a universal threshold for when QE becomes less effective.
Key ideas
- Near-zero short-term rates can motivate central banks to use QE as an additional stimulus tool.
- Bond purchases can lower longer-term yields and encourage a shift from cash into risky assets.
- QE may lose force when risky assets offer little expected return above cash.
- The answers also suggest that low rates may increase precautionary saving and weaken demand.
Tags
Full text
# Why wouldn't quantitative easing work if interest rates approach 0 # Why wouldn't quantitative easing work if interest rates approach 0 I was reading this article on quantitative easing. At some point, this is mentioned, referring to QE: This strategy loses effectiveness when interest rates approach zero, at which point banks have to implement other strategies to kick start the economy. Why would QE lose effectiveness when interest rates approach 0? ## Answer by Helin (score 2, accepted) https://quant.stackexchange.com/a/35373 There are different schools of thoughts on this topic, but as @dm63 pointed out, interest rate approaching zero is not a reason for QE to lose effectiveness; it is in fact a reason for conducting QE in the first place. My preferred narrative goes roughly as follows: In a depressionary environment, investors sell assets and move money into cash. This cuts off capital flows into risky assets and the capital market stops functioning normally. To reverse this vicious cycle, the first step is to lower short-term cash rates to make funding super cheap for those that need it and to make cash unattractive to investors holding cash. After cash return has reached zero, the next step is to conduct QE, starting with bond purchases. This lowers long-term interest rate, incentivizing investors to move money away from cash and back into risky assets (stocks, high yield, etc.). As money flows back into assets, the prices of these assets increase. Not only does this create a positive wealth effect and a virtuous cycle of risk taking, it also lowers funding costs for borrowers/issuers, allowing deleveraging to happen. But as the prices of bonds/stocks/etc. increase, their future expected returns decline. This is actually when QE loses effectiveness – when the expected returns of risky assets are very low relative to cash. When this happens, additional QE won't create as much wealth effect and can't induce investors to move into risky assets any more (if cash and stocks have the same expected return, you'd just hold cash). ## Answer by dm63 (score 2) https://quant.stackexchange.com/a/35361 I don't agree with the statement. It's precisely after short term interest rates approach zero that central banks turn to QE as an additional technique to boost the economy. ## Answer by kris123456 (score 1) https://quant.stackexchange.com/a/35386 If i have a long term goal of say 10 mil and i contribute 10K everymonth. say, i need to contribute for 40 years, which would be 4.8 Mil My contribution + (Compounded) interest is 5.2 Mil. I reach my target and i am a happy man. (Some random interest rate :) ) With Zero interest rates, I need to contribute all 10 Mil from my pocket. i am not making any money on my money, so i better save more. This is the perception of people, who have long term aspirations/plans/goals. When interest rates reach zero, they panic and they stop spending and start saving more. This reduces GDP, causes deflation and further worsens the situation leading to negative interest rates. ## Answer by Alex Taha (score 0) https://quant.stackexchange.com/a/35359 As rates approach zero then next thing is for rates to go negative which comes with its own shortfalls. For example central banks that are in the negative territory need to get out of that so that when the next crisis hits they have some playing room. There could be something I am missing let us wait and see.
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