Problem or solution?
This article explains what Quantitative Easing (QE) is, and looks at whether it is an effective monetary policy tool.
In conventional expansionary monetary policy the central bank buys financial assets, including short term government debt, from commercial banks and financial institutions, through open market operations. This increases the monetary base and lowers the yield (interest rate) on those financial assets.
When interest rates approach zero, conventional monetary policy ceases to work. Central banks then resort to (unconventional) purchases of financial assets with longer term maturities that are further out on the yield curve, thereby lowering long term interest rates. This is QE, and it is expansionary monetary policy on steroids.
QE is distinguished from conventional expansionary policy by:
- the greater range of financial assets that are purchased (now including longer term government bonds);
- a greater focus on reliable signalling (pre-announcement of amount and timing);
- the extent to which the central bank’s balance sheet, and the monetary base, is expanded.
Following the 2008 global financial crisis, deflation and low demand for credit had already brought interest rates close to zero. Banks were constrained in lending money due to bad debts. A clear and present threat of recession / depression existed. Hence more radical measures had to be adopted by the bigger developed economies (US and UK) than just ordinary expansionary monetary policy.
The Federal Reserve embarked on its QE program in 2008, increasing its balance sheet from $800 billion to $4 trillion by 2014. To put this in context, $4 trillion is 25% of the entire US economy. At its height QE in the US amounted to the Fed creating the equivalent of the Irish economy every three months!
Has it worked? It is too early to say. The good news is that the US economy is growing strongly, inflation is not a problem, and unemployment is at its lowest level in five years. Critics will argue that much of the liquidity has gone into financial assets, and point to the 160% increase in the S&P 500 since 2009. However this is a simplistic view, as earnings growth has kept pace with the market movement.
2014 will reveal a clearer picture as the Fed proceeds with tapering of QE, and we will see how the economy performs without QE stimulus. The Fed will have to tread carefully so as not to derail the recovery that has taken some 5 years to engender.
In Japan QE has been tried at least twice. An attempt in early 2000 was unsuccessful as banks, facing few lending opportunities, just sat on the excess liquidity or purchased financial assets.
Not to be deterred, Japan embarked on another round of QE in 2010. In monetary terms the extent of QE in Japan is equal to that of the US, despite the fact that the Japanese economy is about 40% of the size of the US. The Bank of Japan is committed to addressing persistent deflation through QE, and is also seeking to improve export competitiveness by lowering the value of the Yen.
Again, it is too early to say if this will work. The Japanese stock market increased by 57% in 2013 and inflation is now 1%, finally making progress towards Bank of Japan targets. However recent economic figures have been disappointing, the economy grew by only 1% in the final quarter. It appears the Japanese are once again not spending all those Yen. Some commentators have linked the sell-off in emerging markets in January to a withdrawal of this liquidity. Emerging markets are not homogenous and those that have sold off have serious economic issues, so must be judged separately.
The mandate of the ECB prohibits it from engaging directly in QE.
In any case QE is necessarily tailor made to the particular challenges of the economy. The ECB has the uniquely particular challenge of operating a single monetary policy for the 18 economies that constitute the Eurozone.
Notwithstanding that challenge, the ECB is operating an accommodative growth focussed monetary policy within the constraints of its mandate, and it has implemented non-standard liquidity operations.
- Will inflation become a problem with all this printing of money? As long as productivity continues to improve, spare capacity exists, and the labour markets remain weak, it is unlikely that inflationary pressures will emerge in the short term. When they do emerge, central banks will presumably counter by tightening monetary policy.
- What does QE mean for savers? The low bond yields induced by QE pose an asset allocation problem for pension and other fund managers, as negative real returns created by zero interest rates leads to a decline in the value of investments held in bonds. Investors are increasingly forced to look at (riskier) asset classes (equities).
- So what is the problem with QE? From a central bank’s perspective, there isn’t a problem: it is obliged to meet price stability targets (i.e. a modest level of inflation), and once conventional means are not working, it is necessary to move to unconventional means. When inflation finally threatens, the central bank will tighten monetary policy. The expansion of the central bank’s balance sheet is only a problem if it is faced with asset impairments (e.g. a T Bill default) and that could never happen – could it?
- A side effect of QE is that the government is able to run up debt by offloading longer term bonds into the market. Since QE involves the pre-announcement of amount and timing of central bank bond purchases, banks and financial institutions buy that government debt when they otherwise might not.
- We are in uncharted waters. QE at this scale is unprecedented and it is too early to pronounce on its success or otherwise.