Quantitative easing

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Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when standard monetary policy has become ineffective.[1][2] A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions, thus creating money and injecting a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to change money supply, in order to keep market interest rates at a specified target value.[3][4][5][6]

Expansionary monetary policy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates.[7][8][9][10] However, when short-term interest rates are either at, or close to, zero, normal monetary policy can no longer lower interest rates. Quantitative easing may then be used by the monetary authorities to further stimulate the economy by purchasing assets of longer maturity than only short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.[11][12] Quantitative easing raises the prices of the financial assets bought, which lowers their yield.[13]

Quantitative easing can be used to help ensure that inflation does not fall below target.[6] Risks include the policy being more effective than intended in acting against deflation – leading to higher inflation,[14] or of not being effective enough if banks do not lend out the additional reserves.[15] According to the IMF and various other economists, quantitative easing undertaken since the global financial crisis has mitigated the adverse effects of the crisis.[16][17][18]

Contents

Process

Ordinarily, a central bank conducts monetary policy by raising or lowering its interest rate target for the inter-bank interest rate. A central bank generally achieves its interest rate target mainly through open market operations, where the central bank buys or sells short-term government bonds from banks and other financial institutions.[8][10] When the central bank disburses or collects payment for these bonds, it alters the amount of money in the economy, while simultaneously affecting the price (and thereby the yield) for short-term government bonds. This in turn affects the interbank interest rates.[19][20]

If the nominal interest rate is at or very near zero, the central bank cannot lower it further. Such a situation, called a liquidity trap,[21] can occur, for example, during deflation or when inflation is very low.[22] In such a situation, the central bank may perform quantitative easing by purchasing a pre-determined amount of bonds or other assets from financial institutions without reference to the interest rate.[5][23] The goal of this policy is to increase the money supply rather than to decrease the interest rate, which cannot be decreased further.[24] This is often considered a "last resort" to stimulate the economy.[25][26]

Quantitative easing, and monetary policy in general, can only be carried out if the central bank controls the currency used. The central banks of countries in the Eurozone, for example, cannot unilaterally expand their money supply, and thus cannot employ quantitative easing. They must instead rely on the European Central Bank (ECB) to set monetary policy.[27]

History

In Japan

The original Japanese expression for quantitative easing (量的金融緩和, ryōteki kin'yū kanwa), was used for the first time by a Central Bank in the Bank of Japan's publications. The Bank of Japan has claimed that the central bank adopted a policy with this name on 19 March 2001.[28] However, the Bank of Japan's official monetary policy announcement of this date does not make any use of this expression (or any phrase using "quantitative") in either the Japanese original statement or its English translation.[29] Indeed, the Bank of Japan had for years, including as late as February 2001, claimed that "quantitative easing … is not effective" and rejected its use for monetary policy.[30] Speeches by the Bank of Japan leadership in 2001 gradually, and ex post, hardened the subsequent official Bank of Japan stance that the policy adopted by the Bank of Japan on 19 March 2001 was in fact quantitative easing. This became the established official view, especially after Toshihiko Fukui was appointed governor in February 2003. The use by the Bank of Japan is not the origin of the term quantitative easing or its Japanese original (ryoteki kinyu kanwa). This expression had been used since the mid-1990s by critics of the Bank of Japan and its monetary policy.[31]

Quantitative easing was used unsuccessfully by the Bank of Japan (BOJ) to fight domestic deflation in the early 2000s.[11][32][33][34] The Bank of Japan has maintained short-term interest rates at close to zero since 1999. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[35] The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities and equities, and extended the terms of its commercial paper purchasing operation.[36]

After 2007

More recently, similar policies have been used by the United States, the United Kingdom and the Eurozone during the Financial crisis of 2007–2012. Quantitative easing was used by these countries as their risk-free short-term nominal interest rates are either at, or close to, zero. In the US, this interest rate is the federal funds rate. In the UK, it is the official bank rate.

During the peak of the financial crisis in 2008, in the United States the Federal Reserve expanded its balance sheet dramatically by adding new assets and new liabilities without "sterilizing" these by corresponding subtractions. In the same period the United Kingdom also used quantitative easing as an additional arm of its monetary policy in order to alleviate its financial crisis.[37][38][39]

The European Central Bank has used 12-month and 36-month long term refinancing operations (LTRO) (forms of quantitative easing without referring to them as such[40]) through a process of expanding the assets that banks can use as collateral that can be posted to the ECB in return for euros. This process has led to bonds being "structured for the ECB".[41] By comparison the other central banks were very restrictive in terms of the collateral they accept: the US Federal Reserve used to accept primarily treasuries (in the first half of 2009 it bought almost any relatively safe dollar-denominated securities); the Bank of England applied a large haircut.

During its QE programme, the Bank of England bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies.[24] The banks, insurance companies and pension funds can then use the money they have received for lending or even to buy back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency.[citation needed] These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital.[42] Another side effect is that investors will switch to other investments, such as shares, boosting their price and thus encouraging consumption.[24] QE can reduce interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying and financially weaker bodies.

Nevin argued that QE failed to stimulate recovery in the UK and instead prolonged the recession between 2009 and 2012 as it caused a collapse in the velocity of circulation, or rate at which money circulates around the economy. This happened because QE drove down gilt yields and annuity rates and forced pensioners, savers and companies to hoard cash to counter the negative impact of QE on their investment income.[43]

In 2012 the Bank of England itself reckoned that quantitative easing had benefited households differently, according to the assets they hold; richer households have more assets.[44]

At the beginning of 2013 the Swiss National Bank had the largest balance sheet relative to the size of the economy it was responsible for, at close to 100% of Switzerland's national output. 12% of its reserves were in foreign equities. The Federal Reserve's holdings equaled about 20% of U.S. GDP while the ECB's assets were 30% of GDP.[45]

Amounts

The U.S. Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the recession. In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities (MBS).[46] By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing robustly. After the halt in June holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Fed's revised goal became to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2–10-year Treasury notes a month. In November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of Treasury securities by the end of the second quarter of 2011.[47][48] A third round of quantitative easing, or "QE3", was announced by the Federal Reserve in September 2012. The third round includes a plan to purchase US$40 billion of mortgage-backed securities (MBS) per month. Additionally, the Federal Open Market Committee (FOMC) announced that it would likely maintain the federal funds rate near zero "at least through 2015."[49]

The Bank of England had purchased around £165 billion of assets by September 2009 and around £175 billion of assets by end of October 2010.[50] At its meeting in November 2010, the Monetary Policy Committee (MPC) voted to increase total asset purchases to £200 billion. Most of the assets purchased have been UK government securities (gilts), the Bank has also been purchasing smaller quantities of high-quality private sector assets.[51] In December 2010 MPC member Adam Posen called for a £50 billion expansion of the Bank's quantitative easing programme, whilst his colleague Andrew Sentance has called for an increase in interest rates due to inflation being above the target rate of 2%.[52] In October 2011, the Bank of England announced it would undertake another round of QE, creating an additional £75 billion,[53] in February 2012 it announced an additional £50 billion,[54] in July 2012 it announce another £50 billion,[55] bringing the total amount to £375 billion. The Bank of England has said that it will not buy more than 70% of any issue of government debt.[56] This means that at least 30% of any issue of government debt will have to be purchased and held by institutions other than the Bank of England.

The European Central Bank (ECB) said it would focus efforts on buying covered bonds, a form of corporate debt. It signalled initial purchases would be worth about €60 billion in May 2009.[57]

The Bank of Japan (BOJ) increased the commercial bank current account balance from ¥5 trillion yen to ¥35 trillion (approximately US$300 billion) over a 4-year period starting in March 2001. As well, the BOJ tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis. In early October 2010, the BOJ announced that it would examine the purchase of ¥5 trillion (US$60 billion) in assets. This was an attempt to push the value of the yen versus the U.S. dollar down to stimulate the local economy by making their exports cheaper; it did not work.[58] On 4 August 2011 the bank announced a unilateral move to increase the amount from ¥40 trillion (US$504 billion) to a total of ¥50 trillion (US$630 billion).[59][60] In October 2011 the Bank of Japan expanded its asset purchase program by ¥5 trillion ($66bn) to a total of ¥55 trillion.[61]

QE1, QE2, and QE3

The expression "QE2" became a "ubiquitous nickname" in 2010, when used to refer to a second round of quantitative easing by central banks in the United States.[62] Retrospectively, the round of quantitative easing preceding QE2 may be called "QE1". Similarly, "QE3" refers to the third round of quantitative easing following QE2.[63][64]

QE3 was announced on 13 September 2012. In an 11-to-1 vote, the Federal Reserve decided to launch a new $40 billion a month, open-ended, bond purchasing program of agency mortgage-backed securities and also to continue extremely low rates policy until at least mid-2015.[65] According to NASDAQ.com, this is effectively a stimulus program which allows the Federal Reserve to relieve $40 billion dollars per month of commercial housing market debt risk.[66]

On 12 December 2012. The FOMC announced increased the amount of open-ended purchases from $40 billion to $85 billion per month. This is sometimes referred to as "QE4".

Effectiveness

According to the IMF, the quantitative easing policies undertaken by the central banks of the major developed countries since the beginning of the late-2000s financial crisis have contributed to the reduction in systemic risks following the bankruptcy of Lehman Brothers. The IMF states that the policies also contributed to the improvements in market confidence and the bottoming out of the recession in the G7 economies in the second half of 2009.[16]

Economist Martin Feldstein argues that QE2 led to a rise in the stock-market in the second half of 2010, which in turn contributed to increasing consumption and the strong performance of the U.S. economy in late 2010.[18] Former Federal Reserve Chairman Alan Greenspan calculated that as of July 2012 there was "very little impact on the economy" and noted "I'm very surprised at the data".[67] Federal Reserve Governor Jeremy Stein has said that measures of quantitive easing such as large-scale asset purchases "have played a significant role in supporting economic activity".[17]

Economic impact

Quantitative easing may cause higher inflation than desired if the amount of easing required is overestimated, and too much money is created by the purchase of liquid assets.[14] On the other hand, quantitative easing can fail to be effective at spurring demand if banks remain reluctant to lend money to businesses and households. Even then, quantitative easing can still ease the process of deleveraging as it lowers yields. However, there is a time lag between money growth and inflation, inflationary pressures associated with money growth from QE could build before the central bank acts to counter them.[68] Inflationary risks are mitigated if the system's economy outgrows the pace of the increase of the money supply from the easing. If production in an economy increases because of the increased money supply, the value of a unit of currency may also increase, even though there is more currency available. For example, if a nation's economy were to spur a significant increase in output at a rate at least as high as the amount of debt monetized, the inflationary pressures would be equalized. This can only happen if member banks actually lend the excess money out instead of hoarding the extra cash. During times of high economic output, the central bank always has the option of restoring the reserves back to higher levels through raising of interest rates or other means, effectively reversing the easing steps taken.

Increasing the money supply tends to depreciate a country's exchange rates versus other currencies. This feature of QE directly benefits exporters residing in the country performing QE and also debtors whose debts are denominated in that currency, for as the currency devalues so does the debt. However, it directly harms creditors and holders of the currency as the real value of their holdings decrease. Devaluation of a currency also directly harms importers as the cost of imported goods is inflated by the devaluation of the currency.[69]

Risks

Savings and pensions

In November 2010, a group of conservative Republican economists and political activists released an open letter to Federal Reserve Chairman Ben Bernanke questioning the efficacy of the Fed's QE program. The Fed responded that their actions reflected the economic environment of high unemployment and low inflation.[70]

In the European Union, World Pensions Council (WPC) financial economists have also argued that QE-induced artificially low interest rates will have an adverse impact on the underfunding condition of pension funds as “without returns that outstrip inflation, pension investors face the real value of their savings declining rather than ratcheting up over the next few years”[71][72]

Such risks were compounded in 2012 an early 2013 as the UK economy entered a new recessionary phase prompting renewed monetary leniency from the part of the Bank of England, and the European Central Bank became increasingly involved in various “bailout programs” in Cyprus and other “peripheral” Eurozone jurisdictions:

“One of the most significant traits of the Great Recession […] has been the continued monetary complacency of most central banks in the Northern Hemisphere, the Bank of England holding the unenviable distinction of being the loosest. The “quantitative easing” crescendo of the past twelve months has further depleted the real value of government-issued fixed income assets on both sides of the Atlantic, altering the normal functioning of financial markets over a dangerously long period of time, and, more importantly, making it increasingly difficult for pension funds to meet their target returns- even under lenient actuarial assumptions. It’s therefore no surprise that pension fund CIOs are increasingly keen to look for higher yielding investment vehicles within the fixed income space itself such as corporate bonds, issued by domestic/European firms (credit instruments), or dollar or euro-denominated government bonds issued by the developing nations of Asia and Latin America (sovereign debt). Some look even further afield in the quest for higher yields, in the new “infrastructure asset class” originally championed by Canadian and Australian pension schemes” [73]

Housing market over-supply and QE3

The only member of the Federal Open Market Committee to vote against QE3, Richmond Federal Reserve Bank President Jeffrey M. Lacker, said:

"The impetus ... is to aid the housing market. That's an area that's fallen short in this recovery. In most other U.S. postwar recoveries, we've seen a pretty sharp snap back in housing. Of course, the reason it hasn't come back in this recovery is that this recession was essentially caused by us building too many houses prior to the recession. We still have a huge overhang of houses that haven't been sold that are vacant. And it's going to take us a while before we want the houses we have, much less need to build more."[74]

Capital flight

The new money could be used by the banks to invest in emerging markets, commodity-based economies, commodities themselves and non-local opportunities rather than to lend to local businesses that are having difficulty getting loans.[75]

Criticism by BRIC Countries

QE rounds by the central banks of developed nations are criticized by BRIC countries. They share the argument that such actions amount to protectionism and competitive devaluation. As net exporters whose currencies are partially pegged to the dollar, they protest that it causes their inflation to rise and penalizes their industry.[76][77][78][79]

Comparison with other instruments

Qualitative easing

Professor Willem Buiter, of the London School of Economics, 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 [in its] 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.[80]

Credit easing

In introducing the Federal Reserve's response to the 2008–9 financial crisis, Fed Chairman Ben Bernanke distinguished the new program, which he termed "credit easing" from Japanese-style quantitative easing. In his speech, he announced:

Our approach—which could be described as "credit easing"—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.[81]

Credit easing involves increasing the money supply by the purchase not of government bonds, but of private sector assets such as corporate bonds and residential mortgage-backed securities.[82][83] When undertaking credit easing, the Federal Reserve increases the money supply not by buying government debt, but instead by buying private sector assets including residential mortgage-backed securities.[82][83] In 2010, the Federal Reserve purchased $1.25 trillion of mortgage-backed securities (MBS) in order to support the sagging mortgage market. These purchases increased the monetary base in a way similar to a purchase of government securities.[84]

Printing money

Quantitative easing has been nicknamed "printing money" by some members of the media,[85][86][87] central bankers,[88] and financial analysts.[89][90] However, central banks state that the use of the newly created money is different in QE. With QE, the newly created money is used for buying government bonds or other financial assets, whereas the term printing money usually implies that the newly minted money is used to directly finance government deficits or pay off government debt (also known as monetizing the government debt).[85]

Central banks in most developed nations (e.g., UK, US, Japan, and EU) are forbidden by law to buy government debt directly from the government and must instead buy it from the secondary market.[84][91] This two-step process, where the government sells bonds to private entities which the central bank then buys, has been called "monetizing the debt" by many analysts.[84] The distinguishing characteristic between QE and monetizing debt is that with QE, the central bank is creating money to stimulate the economy, not to finance government spending. Also, the central bank has the stated intention of reversing the QE when the economy has recovered (by selling the government bonds and other financial assets back into the market).[85] The only effective way to determine whether a central bank has monetized debt is to compare its performance relative to its stated objectives. Many central banks have adopted an inflation target. It is likely that a central bank is monetizing the debt if it continues to buy government debt when inflation is above target, and the government has problems with debt-financing.[84]

Ben Bernanke remarked in 2002 that the US Government had a technology called the printing press, or today its electronic equivalent, so that if rates reached zero and deflation was threatened the government could always act to ensure deflation was prevented. He said, however, that the Government would not print money and distribute it "willy nilly" but would rather focus its efforts in certain areas (for example, buying federal agency debt securities and mortgage-backed securities).[92][93] According to economist Robert McTeer, former president of the Federal Reserve Bank of Dallas, there is nothing wrong with printing money during a recession, and quantitative easing is different from traditional monetary policy "only in its magnitude and pre-announcement of amount and timing".[94][95] Richard W. Fisher, president of the Federal Reserve Bank of Dallas, warned that a potential risk of QE is, "the risk of being perceived as embarking on the slippery slope of debt monetization. We know that once a central bank is perceived as targeting government debt yields at a time of persistent budget deficits, concern about debt monetization quickly arises." and later in the same speech states that the Fed is monetizing the government debt, "The math of this new exercise is readily transparent: The Federal Reserve will buy $110 billion a month in Treasuries, an amount that, annualized, represents the projected deficit of the federal government for next year. For the next eight months, the nation’s central bank will be monetizing the federal debt."[96]

Altering debt maturity structure

Based on research reassessing the effectiveness of the US Federal Open Market Committee action in 1961 known as Operation Twist, The Economist, based on research by economist Eric Swanson, has posited that a similar restructuring of the supply of different types of debt would have an effect equal to that of QE.[97] Such action would allow finance ministries (e.g., the US Department of the Treasury) a role in the process now reserved for central banks.[97]

See also

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