The Eurosystem’s primary objective is to safeguard price stability in the euro area. The Governing Council of the ECB considers that price stability is best maintained by aiming for a 2% inflation rate over the medium term. This target is symmetric, meaning negative and positive deviations of inflation from the target are equally undesirable.

The Governing Council normally steers the inflation rate by changing the policy rate. If the inflation rate needs to fall, it increases the policy rate. If the inflation rate needs to rise, it lowers the policy rate. But how can monetary policy respond if the inflation rate needs to increase but the policy rate cannot be lowered further?

The Governing Council can then decide that the Eurosystem’s central banks should make large-scale purchases of securities, particularly government bonds. But how can these asset purchases by the central bank increase the inflation rate?

Two mechanisms are at play here. First, central bank money is created when assets are purchased, as central banks pay for them in central bank money. The central bank monetary base thus expands. This generally increases commercial banks’ scope for lending.

Second, the higher demand for assets drives up their market prices. This is down to the standard mechanism in the markets: things become more expensive when demand for them rises. As bond prices rise, bond yields, that is the total return they generate, fall. This is because the return an investor receives when a bond reaches maturity also derives – in addition to the interest paid – from the difference between the redemption amount determined in advance and the now higher price. Therefore, if the price of the bond increases, the bond yield falls.

This decline in yields, meanwhile, has an impact on the interest rates of banks, who use the bond yields as a reference for the interest rate level of their loans to households and enterprises. That is, if bond yields fall, the interest rates on bank loans generally also fall, and therefore the general interest rate level in the economy.

A lower interest rate level makes borrowing cheaper for the government, enterprises and households. This in turn stimulates enterprises’ investment activity and boosts consumers’ demand for durable consumer goods. Aggregate demand rises. Enterprises can thus increase their prices both more easily and by a greater amount. The inflation rate tends to rise – which is precisely what the asset purchases aimed to achieve.

Asset purchases therefore have two major effects. First, they increase the volume – or quantity – of central bank money, which gives commercial banks’ more scope for lending. Second, the longer-term interest rates fall in response to the broad-based asset purchases. This is similar to the effect of a traditional policy rate cut, referred to as monetary policy easing. The term “quantitative easing” is derived from these two effects.

In addition, the lower interest rate level stemming from quantitative easing tends to lead to capital outflows to countries where the interest rate level and thus expected interest income are higher. Such capital outflows lead to falling demand for the domestic currency and bring about a decline in the exchange rate. This makes domestic goods cheaper abroad and thus boosts exports. The increased demand for domestic goods from abroad in turn enables prices to rise more sharply. In this way, too, quantitative easing can raise the inflation rate and move it towards the target.

Depending on medium-term price developments, the asset purchases can be expanded, reduced or suspended. Equally, the central bank can sell securities it has purchased in the market again.