Author: Theo Kim

Under normal conditions, central banks conduct monetary policy by adjusting a short-term policy rate. When that rate approaches its effective lower bound, however, there is little room left for conventional rate cuts. Quantitative easing (QE) offers another way to loosen monetary conditions. The central bank purchases large quantities of long-term securities (usually government bonds) thereby increasing their prices and lowering their yields.

To understand QE, it helps to separate a long-term bond yield into two components. The first is the average short-term interest rate investors expect over the life of the bond. The second is the term premium: the additional compensation investors demand for holding a longer-term asset whose price may fluctuate. QE can reduce long-term yields by affecting either component, although the relative importance of each is difficult to measure.

The signaling channel operates through expected short-term rates. By announcing a large and potentially prolonged asset-purchase program, a central bank may convince investors that its policy rate will remain low for longer than previously expected. The portfolio-balance channel instead operates through the term premium. When the central bank removes long-duration bonds from the market, private investors hold less interest-rate risk and rebalance toward other assets, pushing down yields more broadly.

QE will therefore tend to flatten the yield curve if it lowers long-term yields while the short end remains anchored near zero. The result is not automatic, however. If investors believe QE will successfully raise growth and inflation, expected future interest rates may increase, placing upward pressure on longer-term yields. A QE announcement can thus lower yields immediately while contributing to a steeper curve later as the economic outlook improves.

The effect of QE depends on both the size of the purchases and the message they convey. Markets care about which assets are being purchased, how long the program will last, and what it implies about future policy. This is why tapering or ending QE can move yields even before the central bank sells any bonds. QE affects the yield curve not simply by creating money, but by changing the supply, distribution, and expected path of interest-rate risk.

In October 1990, Britain entered the European Exchange Rate Mechanism, or ERM, which required participating countries to keep their currencies within agreed bands. The pound entered at a central rate of 2.95 Deutsche marks and was not supposed to fall below approximately 2.78 marks. If it approached that floor, the British government and the Bank of England were expected to support it through foreign-exchange intervention or higher interest rates.

By 1992, this commitment had become increasingly difficult to maintain. Britain was experiencing a recession, which ordinarily called for lower interest rates. Germany, meanwhile, was keeping rates high to contain inflationary pressure following reunification. Maintaining the pound’s exchange rate against the Deutsche mark therefore required Britain to follow monetary conditions suited to Germany rather than its own weakening economy.

George Soros and other investors concluded that this conflict was unsustainable. Their trade was conceptually simple: borrow pounds, sell them for Deutsche marks or dollars, and later repurchase the pounds after a devaluation. The Bank of England stood on the other side of the trade, using its foreign-exchange reserves to buy pounds and support the ERM floor. As selling intensified, the government had to demonstrate that it was willing to bear an increasingly high cost to preserve the exchange rate.

On September 16, 1992 (later known as Black Wednesday) the government raised its policy rate from 10 percent to 12 percent and announced that it would rise again to 15 percent. The measures failed to restore confidence because investors doubted that such high rates could be sustained during a recession. Britain withdrew from the ERM that evening, abandoned the proposed second increase, and allowed the pound to float. The currency depreciated, reportedly earning Soros’s fund roughly $1 billion.

The episode is often described as Soros ‘breaking the Bank of England,’ but that framing gives speculators too much credit. They did not create the contradiction between Britain’s domestic economy and its exchange-rate commitment; they simply recognized it and placed a sufficiently large bet against it. Black Wednesday illustrates a broader principle of fixed exchange rates: a government may possess the technical ability to defend a currency, yet still lack the economic or political willingness to do so indefinitely.