Quantitative easing

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Overview

The term quantitative easing describes an extreme form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero. Normally, a central bank stimulates the economy indirectly by lowering interest rates but when it cannot lower them any further it can attempt to seed the financial system with new money through quantitative easing.

In practical terms, the central bank purchases financial assets, including treasuries and corporate bonds, from financial institutions (such as banks) using money it has created ex nihilo (out of nothing).

This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through fractional-reserve banking (deposit multiplication) by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy.[1] However, there is a risk that banks will still refuse to lend despite the increase in their deposits, and in a worst case scenario, possibly lead to hyperinflation.

Quantitative easing is sometimes described as 'printing money', although the central bank actually creates it electronically by increasing the credit in its own bank account.[2]

Examples of economies where this policy has been used include Japan during the Lost Decade (early 2000s), and the US and UK during the global financial crisis of 2008–2009.


Concept

Banks use a practice called fractional-reserve banking whereby they abide by a reserve requirement, which regulates them to keep a percentage of deposits in 'reserve'. The remainder, called 'excess reserves', can be used as a basis for lending. The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of 'thin air' by increasing debt (lending) through a process known as deposit multiplication and thus increase the country's money supply. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet Modern Money Mechanics explains the process.

'Quantitative' refers to the fact that a specific quantity of money is being created; 'easing' refers to reducing the pressure on banks. [3]

A central bank can do this by using the new money to buy government bonds (treasury securities in the United States) in the open market, by lending the new money to deposit-taking institutions, by buying assets from banks in exchange for currency or any combination of these actions. These have the effects of reducing interest yields on government bonds and reducing interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies.

In very simple layman's terms, the central bank creates new money out of thin air. It then uses this money to buy what is essentially an IOU, usually from the government. This money is credited to the bank account of the seller of the IOU. The bank can then use this money as a basis for creating more new money by increased lending.

A state must be in control of its own currency if it is to be able to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on the European Central Bank to implement it.

Willem Buiter has proposed a terminology to distinguish quantitative easing, or an expansion of a central bank's balance sheet, from what he terms qualitative easing, or the process of a central bank adding riskier assets onto its balance sheet:

"Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase it is [sic] monetary liabilities (base money), holding constant the composition of its assets. Asset composition can be defined as the proportional shares of the different financial instruments held by the central bank in the total value of its assets. An almost equivalent definition would be that quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities that holds constant the (average) liquidity and riskiness of its asset portfolio.

Qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet (and the official policy rate and the rest of the list of usual suspects). The less liquid and more risky assets can be private securities as well as sovereign or sovereign-guaranteed instruments. All forms of risk, including credit risk (default risk) are included.[4]

Empirical work on QE

"Quantitative easing has been used on few occasions in the past, so there is little empirical evidence on which to draw. One obvious international example is the experience of Japan earlier this decade. Bernanke et al (2004) found some evidence of an impact on long-term interest rates from quantitative easing. However, Baba et al (2005) concluded that the Bank of Japan’s commitment to keep policy rates low was more important for reducing long-term interest rates than its use of quantitative easing. Asset purchases have also been used to influence government bond yields in the United States in the past. Bernanke (2002) highlighted that the Federal Reserve was successful in maintaining a ceiling onlong-term Treasury bond yields in the 1940s.

Recent announcements of asset purchases by central banks provide further evidence that such purchases can influence asset prices. Kohn (2009) highlighted that the Federal Reserve’s announcements of purchases of mortgage-backed securities and Treasury bonds reduced mortgage and other long-term rates in the United States appreciably — by some estimates by as much as a percentage point. And the Bank of England’s announcement on 5 March that the Bank would be purchasing £75 billion of assets financed by central bank money also appeared to have an impact on UK government bond yields. Gilt yields in the 5 to 25 year maturity range eligible for purchase fell around 40–90 basis points by the end of the day following the announcement."

Federal Reserve announces $900 billion of QE2

Federal Reserve Chairman Ben S. Bernanke embarked on a historic test of unconventional monetary policy by using tools devised during the financial crisis to add fuel to an economy that’s been expanding for 15 months.

Bernanke’s Fed, constrained by a key interest rate near zero and bound by a Congressional mandate to reduce unemployment, yesterday said it would buy $600 billion in Treasury securities through next June in a bid to further reduce long-term borrowing costs and keep prices from falling.

The dollar weakened and stocks rose as the quantity of purchases exceeded the expectations of some investors. Bernanke is gambling he can push down a jobless rate that has been stuck above 9 percent since the recession ended in June 2009 and encourage investors to take more risk without igniting an inflationary surge or fueling asset-price bubbles.

“The Federal Reserve is under-performing on all of its objectives -- by law it has to do something,” said Allen Sinai, chief global economist at Decision Economics Inc. in New York. “I don’t think we pay them to sit on their hands and wait for good times. I will take any mistakes they make in return for the effort.”

Central bankers aim to accelerate U.S. economic growth above a 2.5 percent annual rate to push unemployment lower. The purchases, which come on top of $1.7 trillion of securities the Fed bought through last March to fight the financial crisis, equal roughly a 0.75 percentage-point cut in the federal funds rate, according to the Fed’s internal estimates.

‘Disappointingly Slow’

The Federal Open Market Committee said in its statement yesterday that it was compelled to act because “progress” toward their objectives of full employment and stable prices “has been disappointingly slow.”

“The Fed’s statement is historic in its emphasis on the dual mandate, and doing quantitative easing in a non-financial crisis situation is historic,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. “They are clearly pretty serious about delivering” on jobs and growth.

Combined with about $300 billion in reinvestment of the Fed’s maturing mortgage bonds, total purchases could run as high as $900 billion, or about $110 billion a month, the Fed said. Some economists doubted whether the purchases would have much of an impact.

“I am hesitant to say it is going to yield the kind of impact we need to see to return the economy to trend growth,” said Timothy Duy, a University of Oregon economist who formerly worked at the U.S. Treasury Department. “I am not impressed by the magnitude.”

Economists’ Forecasts

Fifty-three of 56 economists surveyed by Bloomberg News last week predicted the central bank would announce asset purchases yesterday, with 29 forecasting a pledge to buy $500 billion or more. Estimates ranged as high at $1.25 trillion.

New York Fed President William Dudley set expectations at $500 billion in purchases when he said in an Oct. 1 speech that purchases totaling about that amount would add as much stimulus as lowering the Fed’s benchmark rate by 0.5 percentage point to 0.75 percentage point.

Bank of England ends quantitative easing

The Bank of England has decided against further quantitative easing (QE), the policy designed to stimulate growth in the UK economy.

Under QE, the Bank has pumped new money into the economy by buying assets such as government bonds, as a way to boost lending by commercial banks.

Last week, it revealed it had spent all of the £200bn it created for QE.

The Bank also kept interest rates on hold at a record low 0.5% for the 11th consecutive month.

'Further purchases'

While halting QE, the Bank said the £200bn already injected into the economy through the programme would "continue to impart a substantial monetary stimulus to the economy for some time to come".

But it did not close the door on further spending.

"[The Bank] will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them."

One area that it will be looking at is banks' lending to businesses and consumers, as QE was designed to help boost lending.

"Conditions for lending in this country, especially to small and medium-sized businesses, are still much weaker than [the bank] would have wanted," said the BBC's economics editor Stephanie Flanders.

Analysts said concerns about rising inflation were one factor in the Bank's decision to suspend QE.

"Inflation is considerably stronger than the Bank had expected and there are concerns that it won't get back within target [if QE continued]," Jason Simpson from Royal Bank of Scotland told the BBC.

Weak growth

Official figures in January showed that UK consumer prices rose in December by 2.9%, their fastest annual pace for nine months and above the Bank's 2% target.

Bank Governor Mervyn King warned last month inflation was "likely to rise to over 3% for a while", and could go even higher if energy prices and indirect taxes were to increase further, but added that it "should return to target in the medium term".

Although the UK did officially come out of recession in the fourth quarter of 2009 - ending six consecutive quarters of economic decline - the growth was just 0.1%, much less than expected.

For that reason, most analysts expect rates to stay at 0.5% until at least the second half of 2010 for fear of the UK falling back into recession.

Bank of Japan begins buying corporate bonds

The Bank of Japan's first round of corporate bond purchases Friday under its new asset-buying program drew strong responses from financial institutions with the bid-to-cover ratio reaching 2.7.

The central bank has been purchasing long-term Japanese government bonds and Treasury discount bills since last month as part of its comprehensive monetary easing. But Friday's auction drew special attention because it targeted risky assets prone to price volatility.

Following the Lehman shock in 2008, the BOJ in 2009 bought corporate bonds to pump up firms' cash flows. Back then, strict terms for corporate debt purchases discouraged financial institutions from participating, with bids received for each auction falling short of expectations.

This time, the central bank expanded the scope to cover corporate bonds rated BBB or higher instead of just for notes rated A and up.

"Relaxing the terms has had an effect, leading to a better-than-expected bid amount," says a senior bond strategist at Mitsubishi UFJ Morgan Stanley Securities Co.

The lowest yield was 0.151%. Because this is almost on par with yields on JGBs with one to two years remaining to maturity, financial institutions were able to unload corporate bonds to the BOJ at almost the same price as government debt.

Debate surrounds quantitative easing 2.0

The debate over a second round of US quantitative easing is heating up.

And with it, a rather uncomfortable situation for the Federal Reserve.

Without getting too wonk-ish, the idea is that the Taylor Rule beloved by economists currently suggests the need for a (real) negative funds rate. To date that’s been achieved via zero per cent interest rates, plus the Fed’s 2009 $300bn Treasury-buying programme (QE) to lower long-term yields.

The difficulty is what happens if long-term yields don’t stay down.

As the Washington Post notes, even during the Fed’s 2009 QE, rates on 10-year bonds temporarily spiked amid concerns the central bank was printing money to fund budget deficits. If anything, deficit concerns have only deepened in the past year. Which means the Fed might have to figure out a way to keep rates low without stirring up deficit hawks at the same time. Enter QE II — with a difference.

Deutsche Bank’s Dominic Konstam explains:

Despite the Fed’s apparent willingness to consider additional stimulus, we believe the logic of more QE to lower yields is somewhat misplaced since yields are likely to fall anyway as risk assets decline. The policy consensus seems to be that Taylor rules dictated a negative funds rate that was effectively achieved through a near-zero funds rate, for an extended period plus QE that “lowered” longer-term yields as well. In principle if longer-term yields did not fall, as risk assets declined, a case could be made for QE to steer them lower. This may be relevant if it turns out that the Fed wants yields at say 1 ½ percent, but does not seem relevant since there is sufficient scope for yields to fall well below 3 percent in the current environment.

We think instead that the QE debate should be viewed as ultimately amounting to a credible threat to keep yields low, i.e., in a 2- to 3-percent range, rather than as an attempt to propel them meaningfully lower. More specifically its relevance will become evident if risk premia return in the long end, reflecting say concerns about more fiscal stimulus or lack of fiscal consolidation. While this is not central to the Fed’s internal policy debate now, it may become more important as we approach the November elections. Prospects for fiscal tightening might appear to increase (as Republicans vow fiscal rectitude), but the likelihood of post-election gridlock suggests disappointment. If risk assets are more stable by then and, even if deflation risks have abated, the role of QE would be more in the context of buying time for appropriate fiscal tightening without derailing the recovery. And here’s the big difference. Instead of buying US Treasuries on an unsterilised basis — which was the method of the Fed’s last bout of QEasing — this time around, the central bank would sterilise.

And the benefits, Konstam says, would be myriad:

Typically the Fed manages short rates with an eye on long-term risk premia, primarily reflecting inflation risk. The Greek problem is an example where markets can quickly lead the process and plunge the economy into an enforced deflation. The danger is that US fiscal dynamics are not particularly good either, absent a strong recovery so that risk premia could rise once the dust settles on the initial flight to quality. This would be exacerbated if for example the Administration considered more fiscal stimulus.

QE in these circumstances could be sterilized via reverse repos, term deposits or effectively neutralized by raising interest on reserves. The result would be a substantial twist of the yield curve. Mid-2011 2s might be around 1 ½ percent with a policy rate of, say, 1 percent, but 10s could be 2 ½ to 3 percent. Sterilization would be a way to placate the hawks. Net there is no new monetary stimulus via the Fed’s balance sheet. Yet there is a removal of unwarranted risk premia in return for a delay in fiscal consolidation. Some might welcome higher short rates if it helped reduced precautionary money balances (velocity rises). This is of course more likely if growth is stronger – but with an outlook that is still highly uncertain.

Foreign investors hold around half of the Treasuries outstanding. Ultimately they are the marginal pricers of risk premia. Given their concern for euro periphery financing, it is reasonable to assume they will be among the first to expect appropriate fiscal consolidation if and when downside economic risks abate. The beauty of sterilized QE is that they would be pushed to purchase shorter-term Treasuries as the Fed purchased longer-term Treasuries. To the extent that they are comfortable with low inflation in the short term, but fear long-term inflation risk, this is appropriate and a stable outcome. It allows them to revalue their currencies on that horizon too. The alternative would be to revalue more rapidly and obviate the need to invest in dollars altogether . . .

It is too early to say whether Fed policy will embrace the possibility of sterilized QE to contain long-end risk premia. And perhaps it may not need to if markets are “well behaved”. However, the powerful logic is that unless there is a very strong recovery that allows more rapid fiscal consolidation, either markets need to behave and maintain low long rates or the Fed will need to threaten sterilized QE. It suggests that over the medium term as well as the short term, yield curves are prone to be sustainably flatter.

Finally there is also a certain neat logic to policymakers standing up to free markets. First with regulatory reform and maybe, second, with a greater use of central bank balance sheets to dictate interest rates. The use of the word Twist is not incidental here.

We are very much talking about a redux of the Fed’s 1961- 1965 Operation Twist. In that episode, the US sold short-term government debt to drive up yields — in an effort to attract capital inflow — and bought long-term government debt to suppress yields in an effort to encourage investment.

Sound familiar?

There’s a great explanation of Twist available here, on economist Bill Mitchell’s blog, as well as a debate of its efficacy. One point to note though is that — as Konstam’s last paragraph suggests — there is very much a markets vs central bank theme running through the QE II/Operation Twist debate.

Arguments against QE

Ben Bernanke’s speech at Jackson Hole on Friday will reportedly discuss the pros and cons of further monetary easing in the US. This debate has suddenly taken on a new sense of urgency, because the weakening in US economic data seems to have accelerated quite markedly during August. Under normal circumstances, the Fed would probably now be cutting the Fed Funds rate, and only a few convinced hawks would object too vehemently to this. However, because the only option now left to the Fed is to increase unconventional easing, there are many people (including several on the FOMC itself) arguing that the Fed should do nothing. What are the arguments for doing nothing, and do they make sense?

“Quantitative easing was tried in 2008/09, and it did not work.”

True, the Fed expanded the size of its balance sheet by about $1.5 trillion dollars in a matter of a few weeks in 2008, so QE was certainly tried. We do not know what would have happened if this had not been done, but there seems a strong chance that the banking collapse would have been worse, and the economic recession much deeper, without QE. In that sense, the policy ”worked”, but the cure does not seem to have been permanent. It is hard to isolate the real reason for this. It may be because QE is an ineffective policy tool, or it may be because not enough of it has yet been done. Take your pick.

“QE does nothing to increase expenditure in the economy.

There are no proven links between QE and aggregate demand.” This argument is widely used, but seems dubious. The form of QE now being contemplated involves the purchase of government bonds by the central bank. It seems fairly clear that this will reduce long term interest rates below the levels they would otherwise have reached (provided that inflation expectations do not surge - see below). It also seems likely that lower bond yields will support equity prices and the housing market. So there should be some link to aggregate demand, even if fairly weak.

“QE must be inflationary because it is always inflationary to print money.”

In the long run, this must be right, if (and only if) you accept that the ratio of central bank money to broad money is fixed, and that the relationship between broad money and the general price level is also fixed. (These are Milton Friedman-type long run constants.) However, as we have seen very clearly in the past two years, these ratios are not fixed in the short run, so the relationship between central bank money and inflation can vary dramatically for many years at a time. It is only if QE is not reversed when the rest of the economy returns to normal that it would create unwanted inflation.

“It will be impossible to reverse QE when the need arises.

Therefore the inflation will rise eventually.” From a technical stand-point, this is not a worry, since the Fed can easily sell its treasury holdings, or allow them to expire. However, it could be a problem in a real politik sense, since politicians may not like the impact of these transactions on interest rates, which would make it more difficult to fund the government’s ongoing deficit. These politicians may therefore start to interfere with the Fed’s independence. This does indeed seem worrying, though not necessarily in the short term.

“Even if QE does not cause inflation in the near term, it will raise inflationary expectations, leading to higher not lower bond yields.”

So far, this has not happened. In fact, the reverse - since QE started, inflation expectations have fallen, allowing bond yields to come down sharply. But it is certainly a frightening possibility which should be very carefully monitored. If the public were to draw a link between QE and future inflation, then present inflation could easily rise, even with the economy still in recession. The Fed will be rightly paranoid about the danger of rising inflation expectations, since this is the exact opposite of a free lunch for the economy.

“If the Fed buys government bonds, then it will only encourage the government to run bigger deficits.”

Probably true, since the government could run larger deficits without suffering very significant effects on long term interest rates. Some people may actually like this, because they favour bigger deficits anyway. But it is not very likely that the Fed would be in this camp, since they have spent decades arguing for smaller deficits.

“QE will weaken the Fed’s balance sheet, and undermine confidence in the institution.”

This was a very powerful argument in Japan in the 1990s, which reduced the amount of quantitative easing which the BoJ was willing to undertake. If the Fed simply buys Treasuries, it is hard to see how this weakens the balance sheet, unless you believe that the US government could default on its debt. However, if the Fed were to buy private sector assets, like securitised debt and/or equities, then it could subsequently have to take mark-downs on these assets, and many people would see this as a problem. But the Fed probably should not be treated like a private bank, which would suffer a loss of solvency if it suffers a mark-down on its assets. The Fed does not have to mark-to-market like a private bank. And, anyway, does it ultimately matter if the Fed has a negative net worth? The answer would be yes if it undermines the public’s faith in the institution, causing people to reduce their holdings of dollars, in exchange for goods, or foreign currencies. But this is just another way of saying that there is an inflation constraint on the Fed’s ability to increase QE, which everyone would accept. So the balance sheet argument only holds as a special case of the inflation argument.

There are probably many other arguments that I have missed, or which are similar to the above. We will all reach our own judgment on whether these arguments are powerful enough to prevent a dose of monetary easing which, in more conventional circumstances, would be accepted by almost everybody. For what it is worth, my own judgment is that the Fed should go ahead, but I do not lightly dismiss the case against. It is certainly not what people in the markets would call a “no brainer”.

QE's effect on bank balance sheets

Image:QE on bank balnce sheet.png

References

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