by Michael Collins, Investment Commentator at Fidelity
September 2012
The Federal Reserve has conducted two and may launch a third. The Bank of England has boosted the size of its program three times. The Bank of Japan’s first one lasted five years and after a four-year break it had another go. We are talking about episodes of quantitative easing, an ungainly term for an unconventional central-bank weapon. The big question today is whether these asset-buying programs work. Or should central bankers resort to other tactics to revive their economies?
To evaluate quantitative easing, it helps to understand what it is – and the Fed and the Bank of Japan have different concepts of the practice – and what it’s not. Quantitative easing, broadly speaking, is a policy option that has its origins in Milton Friedman’s assessment that while interest rates were low during the 1930’s Great Depression money policy was still tight because banks had little money to lend. Quantitative easing is an attempt to inject money into a struggling economy via the banking system when interest rates are already close to zero – as in conventional monetary-policy tools are spent.
The way quantitative easing works in most cases is that a central bank creates electronic money by a pre-set amount that ends up as a liability on its balance sheet. As it does this, it buys the equivalent amount of assets (usually financial assets such as government and corporate bonds) that sit on the asset side of its balance sheet. The commercial banks and other institutions selling these assets will then have extra money in their accounts with the central bank, which then boosts the monetary base – defined as coins and notes at banks and circulating in the economy, plus bank reserves held by the central bank.
Quantitative easing is not money printing, which is tied to fiscal policy because it’s about putting money in the hands of the public, even if it has a similar effect. Governments can be said to be printing money when, instead of borrowing from the public, they let central banks finance fiscal deficits or when central banks monetise government debt. (The Treasury’s books show a debt to the central bank in these circumstances.) The distinction is important because it reveals the political advantage quantitative easing offers policymakers – it enables large amounts of money to be available for productive economic use without adding to a government’s budget deficit. Washington’s budget shortfall would have jumped to 15% of GDP – Greek levels – if the Fed’s second burst of quantitative easing was money printing (and was done within one fiscal year). Imagine the political and financial firestorm if President Barack Obama sought Congress’ approval for that, even if the jolt to the economy from such fiscal stimulus would have been huge.
For and against
The aim of quantitative easing is to give banks more money to lend while reducing long-term interest rates for consumers and business. Central-bank asset-buying counteracts deflationary forces and prevents the contraction in the money supply that paralysed economies in the 1930s. Signs that policymakers are taking decisive steps to help the economy can revive consumer and business confidence. The asset-buying may undermine a country’s exchange rate, thereby giving an economy an export boost. Higher bond prices push more money into equities when institutional investors rebalance and a stock-induced boost to wealth can help consumption.
What can go wrong? Critics warn that these asset-buying schemes foster risky investment, overinflate asset prices, trigger inflation and are ineffective economic stimulus as they fail to boost demand as targeted fiscal stimulus does. Banks can simply sit on the fresh money rather than lend it. Central banks can lose money for their governments if the value of the new securities on their balance sheets plunges. There are doubts about how easily these programs can be unwound. Trading partners may regard the export boost these programs give a country as the start of a currency war – that’s how China reacted to the Fed’s second serving. The fact that these programs have an intended end can be self-defeating. Even if they do any good, these programs face diminishing returns if extended.
Enough episodes of quantitative easing have been undertaken to test its worth. The policy was first tried on a large-scale basis by the Bank of Japan from 2001 to 2006 (and again from 2010). When the program started 11 years ago, Japan’s economy was mummified even though benchmark interest rates had been at zero since 1999, the banking system was feeble and deflation a pest. The Bank of Japan’s asset-buying spree kept the monetary base excluding cash in circulation at the desired quantity of about 7% of GDP, double what was needed to keep its benchmark rate at zero. (The term quantitative easing comes from the Bank of Japan’s strategy to target a desired quantity of bank reserves.)
The results of Japan’s experiment were unimpressive, according to a Fed study in 2011. Deflation persisted. Economic growth picked up in 2002 but barely. Bank lending slid over the five years. “It is possible that (the program) exerted positive effects, but that these were simply overwhelmed by the drag on aggregate spending coming from severe weakness in the banking sector and balance-sheet problems among households and firms,” the study says.1 Japan’s economy has done much under the second burst of asset-buying either.
US appraisal
Fed and other studies of the quantitative easing tried in the US since the financial crisis struck are as lukewarm in their evaluations, if not contradictory. It’s worth noting that the Fed regards what it calls “credit easing” as conceptually different from the quantitative easing pursued by the Bank of Japan even though both expand central-bank balance sheets – the Fed’s, for instance, has ballooned by US$2.9 trillion since September 2008. The Fed’s distinction comes down to the fact that the Bank of Japan seeks to influence its benchmark rate by targeting a quantity of bank reserves that are central-bank liabilities, whereas the US central bank focuses on the composition of the loans and securities on the assets side of its balance sheet for it wants to lower key household and business interest rates. For this reason, the Fed’s extended first round of quantitative easing entailed US$1.73 trillion of purchases of mortgage-backed securities, agency debt and government securities. The second round of quantitative easing involved US$600 billion of spending on government bonds.
Fed modelling shows that the two rounds of quantitative easing helped avoid any 1930s-style depression because they boosted output by almost 3% and bolstered employment by more than two million “relative to what otherwise would have occurred”.2 Another Fed study in 2012 found that the Fed’s two rounds of quantitative easing and its US$400 billion program to sell short-based paper on its balance sheet for longer-term bonds (the so-called “operation twist” that was expanded by another US$267 billion after the study was released) reduced the yield on the 10-year Treasury bond by “about 100 basis points”.3 Research in 2012 out of John Hopkins University, however, says any reduction in interest rates from asset-buying programs was fleeting. “To the extent that longer-term interest rates are important for aggregate demand, unconventional monetary policy at the zero bound has had a stimulative effect on the economy, but it might have been quite modest,” the paper says.4
A Boston Fed study in 2010 found the Fed’s first quantitative-easing program, which spent US$1.25 trillion on mortgage-backed securities, reduced interest rates for borrowers and boosted borrowing but mainly by people with “high credit scores”.5 The latter point means the stimulus to the economy was muted because the people who benefited had excellent access to credit anyway.
New York Fed analysis is more optimistic about the macroeconomic boost from the Fed’s second round of quantitative easing, even if it judged the stimulus to be “moderate”. “Our simulations suggest that such a program increases GDP growth by less than half a percentage point, although the effect on the level of GDP is very persistent,” the 2011 study says.6 Still, the US economy is only expanding at a sub-2% annual pace and the jobless rate is stuck above 8%.
Bank of England studies are upbeat about its bond-buying scheme, which started at 200 billion pounds (A$304 billion) in 2009 and has been extended to 375 billion pounds. A 2011 study found the program had depressed bond yields by “around 100 basis points” and the “evidence suggests that the policy had economically significant effects – equivalent to a 150 to 300 basis point cut in (the cash) rate.”7 This has not been enough to prevent the UK economy contracting though under the austerity measures imposed in recent times.
Part of a package
Fans of quantitative easing think the policy works better if at the same time central banks relax their stances towards inflation. Inflation of say 3% to 4%, instead of the 2% targeted in the US and UK, would help these debt-heavy, consumption-challenged economies because it would erode the real value of debt, lower real interest rates and accelerate spending just as banks had more money to lend and interest rates were falling.
Policymakers, however, are unlikely to drop their anti-inflation stances of recent decades and allow central banks to set higher inflation targets.
Quantitative easing would certainly work better (or even be redundant) if it was timed with the grand steps that politicians in the eurozone, Japan, UK and US need to take to address their country’s economic challenges. But the eurozone is baulking at the banking, fiscal and political integration needed to make its monetary union work. Japanese policymakers are fearful of adding to government debt, which already equals 230% of GDP. The Conservative-led coalition in the UK has too much political capital invested in its austerity drive to stop its sabotage of the UK economy. Anti-tax (and, in effect, pro-deficit) Republicans will use their numbers in Congress to block short-term stimulus and any long-term plan to fix government finances if these plans raise taxes.
Therefore, for all its risks and marginal worth, quantitative easing remains the only viable stimulus option for policymakers because it is the only politically acceptable weapon available when interest rates can no longer be cut and fiscal stimulus is demonised. Expect the episode count of asset-buying financed with central-bank money to increase, even if such steps lack bite.
Financial information comes from Bloomberg unless stated otherwise.
1 Board of Governors of the Federal Reserve System. International finance discussion papers. Number 1018. “Quantitative easing and bank lending: Evidence from Japan.” David Bowman, Fang Cai, Sally Davies, and Steven Kamin.
June 2011.
2 Ben Bernanke, Chairman of the Federal Reserve, speech “Monetary policy since the onset of the crisis.” 31 August 2012. http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm
3 Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C. “Term structure modelling with supply factors and the Federal
Reserve’s large-scale asset purchase programs.” Canlin Li and Min Wei. 30 May 2012. Page 1 and 29.
4 Jonathan H. Wright. Department of Economics, John Hopkins University. “What does monetary policy do to long-term interest rates at the zero lower bound?” 9 May 2012. Page 18.
5 Federal Reserve Bank of Boston. “$1.25 trillion is still real money: Some facts about the effects of the Federal Reserve’s mortgage market investments.” Andreas Fuster and Paul S. Willen. 18 November 2010. Pages 1 to 5 and 25 to 28.
6 Federal Reserve Bank of New York Staff Reports. “The macroeconomic effects of large-scale asset purchase programs. Han Chen, Vasco Cúrdia, Andrea Ferrero. December 2011. Abstract.
7 Bank of England. “The United Kingdom’s quantitative easing policy: design, operation and impact.” By Michael Joyce, Matthew Tong and Robert Woods of the Bank’s Macro Financial Analysis Division. Quarterly Bulletin 2011 Q3. Page 211.
