In an attempt to bolster the economy, the Federal Reserve announced a fresh round of bond purchases to replace Operation Twist, the stimulus program that is set to expire this month. It will spend $US45 billion a month to buy treasury bonds, in addition to the $US40 billion of mortgage bonds it has been buying since September.
Senior lecturer in the School of Economics at the University of Sydney, Graham White, explains the concept of quantitative easing.
The term “quantitative easing” is typically used to refer to central bank actions in recent years - namely in Japan during the early 2000s and in the US, England and Eurozone since 2007 - to inject liquidity into the financial system as a means of providing a monetary stimulus to the economy at a time when the normal mechanics of monetary policy are difficult to apply.
To understand this a bit better, it is useful to consider first the similarities and differences between quantitative easing and conventional monetary policy.
Conventional monetary policy
Conventional monetary policy operates by manipulating the quantity of short-term liquid reserves that banks hold with the central bank (called exchange settlement accounts in Australia). This is done to maintain a particular target rate of interest on funds lent between banks in the overnight market. In Australia this is known as the cash rate, and in the US as the Federal Funds rate.
Monetary policy changes in Australia typically involve the Reserve Bank changing the target overnight rate and supporting that new target by injecting funds or withdrawing funds from these accounts. It does this by purchases or sales of short-term securities with banks.
By changing the cash rate, it is hoped that this will ultimately feed through into other interest rates, in turn affecting expenditures by consumers and firms and, eventually, inflation.
By contrast, quantitative easing comes into play when there is a need to stimulate economic activity and/or prevent deflation (falling prices), but the overnight target rate of interest (and the preferred instrument of monetary policy in “normal times”) is near its lower limit – in other words, close to zero.
If this occurs, the central bank would purchase financial assets across a wider spectrum rather than only short-term securities to inject liquidity into the system.
The central bank may also inject funds through lending to some financial institutions usually at a rate (in the US known as the discount rate) above the target rate of the central bank.
For example, early US Federal Reserve responses to the GFC involved reducing the discount rate and also widening the pool of institutions that could access funds this way.
In effect, the policy of quantitative easing renders the asset balance sheets of the banks and other institutions involved more liquid. The balance sheet of the central bank becomes bigger as it purchases more assets and correspondingly injects more of its own liabilities into the system, which is another way of looking at currency and liquid reserves of the banks.
The act of the central bank purchasing these types of assets may push their prices up and their yields down.
In terms of affecting a sluggish economy, quantitative easing is therefore intended to work by making banks more liquid and affecting longer-term interest rates somewhat more directly.
A key aim of this type of policy is to bolster confidence in the liquidity of the financial system. In turn, it’s hoped this confidence will support the financing of the real side of the economy in the face of the depressing effects of shocks like the GFC.
In other words, it is hoped that the policy will support the financing of expenditures by households and firms which drives aggregate demand for goods and services, the rate at which the economy is growing and what’s eventually going to happen to the unemployment rate.
But “conventional” monetary policy - as it’s sometimes referred to - need not be just about bolstering liquidity for the whole financial system; it can be just as much about strengthening particular parts of the financial or credit market.
This is the view taken by Chairman of the US Federal Reserve Ben Bernanke, who prefers to call the US version of the policy “credit easing”.
For Bernanke, it’s about focusing on asset purchases and loans to the parts of the financial system that most “affects credit conditions for households and businesses”.
Does it work?
How successful is quantitative easing likely to be?
The answer depends on whether the key constraint facing sluggish economies is the banking and financial sector’s willingness to lend and thus whether the key problem is what one may call a because economies are liquidity-constrained. If they are, then quantitative easing may be useful.
On the other hand, if the problem is a general expectation of low growth constraining investment expenditure by firms, and uncertainty about income and employment constraining expenditure by households, then liquid credit markets and cashed-up banks alone will not necessarily do much to help.
In these cases, quantitative easing may be likened to “pushing on a string”, as noted by Keynes in the 1930s.
Arguably, this may have been the problem for the lack of success of this kind of policy in the case of Japan between 2001 and 2006.
As noted by Shigenori Shiratsuka from the Bank of Japan, while the Bank’s quantitative easing may have helped stabilise Japan’s financial system, “such stimulatory effects failed to be transmitted to outside of the financial system” with “limited effects on aggregate variables such as output” (Bank of Japan Discussion Paper, 2009).
In this regard, it is tempting to suggest that quantitative easing — to use the words of the economic theorist — is at best a necessary but not sufficient condition for stimulating depressed economies. To borrow a phrase,which is usually used inappropriately by politicians to excuse under-resourcing of the public sector and which seems more appropriate in relation to quantitative easing, throwing money at the problem may not be the solution.