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Posts Tagged ‘QE’

Active or passive QT? The Fed’s future approach to monetary policy

The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.

But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.

This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.

As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”

A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.

The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.

Articles
Fed’s asset shift to pose new test of economy’s recovery, resilience Reuters, Howard Schneider and Richard Leong (6/4/17)
Federal Reserve likely to begin cutting back $4.5 trillion balance sheet this year Washington Post, Ana Swanson (5/4/17)
Why the Fed’s debate about shrinking its balance sheet really, really matters Money Observer, Russ Mould (7/4/17)
The Fed and ECB keep a cautious eye on the exit Financial Times (7/4/17)
Get ready for the Fed’s next scary policy change CBS Money Watch, Anthony Mirhaydari (5/4/17)
The Fed wants to start shrinking its $4.5 trillion balance sheet later this year Business Insider, Akin Oyedele (5/4/17)
Inside the Fed’s March Meeting: The Annotated Minutes Bloomberg, Luke Kawa, Matthew Boesler and Alex Harris (5/4/17)
QE was great for asset prices – will ‘QT’ smash them? The Financial Review (Australia), Patrick Commins (7/4/17)
Shrinking the Fed’s balance sheet Brookings, Ben Bernanke (26/1/17)

Data
Selected data Board of Governors of the Federal Reserve System

Questions

  1. Distinguish between active and passive QT.
  2. If QE is a form of expansionary monetary policy, is QT a form of contractionary monetary policy?
  3. Could QT take place alongside an expansion of broad money?
  4. What dangers lie in the Fed scaling back its holdings of government (Treasury) bonds and mortgage-backed securities?
  5. Why is it unlikely that the Fed will reduce its holdings of securities to pre-crisis levels?
  6. Why are the Bank of England, the ECB and the Bank of Japan still pursuing a policy of QE?
  7. What are the implications for exchange rates of QT in the USA and QE elsewhere?
  8. Find out data for the monetary base, for narrow money (M1) and broader money (M2) in the USA. Are narrow and/or broad money correlated with Federal Reserve asset holdings?
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Interest rates – too low, for too long?

Interest rates have been at record lows across the developed world since 2009. Interest rates were reduced to such levels in order to stimulate recovery from the financial crisis of 2007–8 and the resulting recession. The low interest rates were accompanied by extraordinary increases in money supply under various rounds of quantitative easing in the USA, UK, Japan and eventually the eurozone. But have such policies done harm?

This is the contention of Brian Sturgess in a new paper, published by the Centre for Policy Studies. He maintains that the policy has had a number of adverse effects:

 •  There will be nothing left in the monetary policy armoury when the next downturn occurs other than even more QE, which will compound the following problems.
 •  It has had little effect in stimulating aggregate demand and economic growth. Instead the extra money has been used to repair balance sheets and support unprofitable businesses.
 •  It has inflated asset prices, especially shares and property, which has encouraged funds to flow to the secondary market rather than to funding new investment.
 •  The inflation of asset prices has benefited the already wealthy.
 •  By keeping interest rates down to virtually zero on savings accounts, it has punished small savers.
 •  By rewarding the rich and penalising small savers, it has contributed to greater inequality.
 •  By keeping interest rates down to borrowers, it has encouraged households to take on excessive amounts of debt, which will be hard to service if interest rates rise.
 •  It has lowered the price of risk, thereby encouraging more risky types of investment and the general misallocation of capital.

Sturgess argues that it is time to end the policy of low interest rates. Currently, in all the major developed economies, central bank rates are below the rate of inflation, making the real central bank interest rates negative.

He welcomes the two small increases by the Federal Reserve, but this should be followed by further rises, not just by the Fed, but by other central banks too. As Sturgess states in the paper (p.12):

In place of ever more extreme descents into the unknown, central banks should quickly renormalise monetary policy. That would involve ending QE and allowing interest rates to rise steadily so that interest rates can carry out their proper functions. Failure to do so will leave the global financial system vulnerable to potential shocks such as the failure of the euro, or the fiscal stresses in the US resulting from the unfinanced spending plans announced by Donald Trump in his presidential campaign.

Although Sturgess argues that the initial programmes of low interest rates and QE were a useful response to the financial crisis, he argues that they should have only been used as a short-term measure. However, if they were, and if interest rates had gone up within a few months, many argue that the global economy would rapidly have sunk back into recession. This has certainly been the position of central banks. Sturgess disagrees.

Articles
Damaging low interest rates and QE must end now, think thank warns The Telegraph, Julia Bradshaw (23/1/17)
QE has driven pension deficits up, think-tank argues Money Marketing, Justin Cash (23/1/17)
Hold: The ECB keeps interest rates and QE purchases steady as Mario Draghi defends loose policy from hawkish critics City A.M., Jasper Jolly (19/1/17)
Preparing for the Post-QE World Bloomberg, Jean-Michel Paul (12/10/16)

Paper
Stop Depending on the Kindness of Strangers: Low interest rates and the Global Economy Centre for Policy Studies, Brian Sturgess (23/1/17)

Questions

  1. Find out what the various rounds of quantitative easing have been in the USA, the UK, Japan and the eurozone.
  2. What are the arguments in favour of quantitative easing as it has been practised?
  3. How might interest rates close to zero result in the misallocation of capital?
  4. Sturgess claims that the existence of ‘spillover’ effects has had damaging effects on many emerging economies. What are these spillover effects and what damage have they done to such economies?
  5. How do low interest rates affect interest rate spreads?
  6. Have pensioners gained or lost from QE? Explain how the answer may vary between different pensioners.
  7. What is meant by a ‘natural’ or ‘neutral’ rate of interest (see section 3.2 in the paper)? Why, according to Janet Yellen (currently Federal Reserve Chair, writing in 2005), is this somewhere between 3.5% and 5.5% (in nominal terms)?
  8. What are the arguments for and against using created money to finance programmes of government infrastructure investment?
  9. Would helicopter money be more effective than QE via asset purchases in achieving faster economic growth? (See the blog posts: A flawed model of monetary policy and New UK monetary policy measures – somewhat short of the kitchen sink.)
  10. When QE comes to an end in various countries, what are the arguments for absorbing rather than selling the assets purchased by central banks? (See the Bloomberg article.)
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A seven-year emergency

Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.

Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.

But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.

Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.

Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.

Some indication that the ‘emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.

Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.

The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.

It would seem that the emergency continues!

Articles
QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)

ECB materials
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi

Questions

  1. What are meant by narrow and broad money?
  2. What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
  3. Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
  4. Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
  5. Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
  6. Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
  7. Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
  8. What are the disadvantages of quantitative easing?
  9. What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
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Has QE stimulated or dampened investment?

It is now some seven years since the financial crisis and nearly seven years since interest rates in the USA, the eurozone, the UK and elsewhere have been close to zero. But have these record low interest rates and the bouts of quantitative easing that have accompanied them resulted in higher or lower investment than would otherwise have been the case? There has been a big argument about that recently.

According to conventional economic theory, investment is inversely related to the rate of interest: the lower the rate of interest, the higher the level of investment. In other words, the demand-for-investment curve is downward sloping with respect to the rate of interest. It is true that in recent years investment has been low, but that, according to traditional theory, is the result of a leftward shift in demand thanks to low confidence, not to quantitative easing and low interest rates.

In a recent article, however, Michael Spence (of New York University and a 2001 Nobel Laureate) and Kevin Warsh (of Stanford University and a former Fed governor) challenge this conventional wisdom. According to them, QE and the accompanying low interest rates led to a rise in asset prices, including shares and property, rather than to investment in the real economy. The reasons, they argue, are that investors have seen good short-term returns on financial assets but much greater uncertainty over investment in physical capital. Returns to investment in physical capital tend to be much longer term; and in the post-financial crisis era, the long term is much less certain, especially if the Fed and other central banks start to raise interest rates again.

“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”

This analysis has been challenged by several eminent economists, including Larry Summers, Harvard Economics professor and former Treasury Secretary. He criticises them for confusing correlation (low investment coinciding with low interest rates) with causation. As Summers states:

“This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation. …If, as Spence and Warsh assert, QE has raised stock prices, this should tilt the balance toward real investment.”

Not surprisingly Spence and Warsh have an answer to this criticism. They maintain that their critique is less of low interest rates but rather of the form that QE has taken, which has directed new money into the purchase of financial assets. This then has driven further asset purchases, much of it by companies, despite high price/earnings ratios (i.e. high share prices relative to dividends). As they say:

“Economic theory might have something to learn from recent empirical data, and from promising new thinking in behavioral economics.”

Study the arguments of both sides and try to assess their validity, both theoretically and in the light of evidence.

Articles
The Fed Has Hurt Business Investment The Wall Street Journal, Michael Spence and Kevin Warsh (26/10/15) [Note: if you can't see the full article, try clearing cookies (Ctrl+Shift+Delete)]
I just read the ‘most confused’ critique of the Fed this yea Washington Past, Lawrence H. Summers (28/10/15)
A Little Humility, Please, Mr. Summers The Wall Street Journal, Michael Spence and Kevin Warsh (4/11/15) [Note: if you can't see the full article, try clearing cookies (Ctrl+Shift+Delete)]
Do ultra-low interest rates really damage growth? The Economist (12/11/15)
It’s the Zero Bound Yield Curve, Stupid! Janus Capital, William H Gross (3/11/15)
Is QE Bad for Business Investment? No Way! RealTime Economic Issues Watch, Joseph E. Gagnon (28/10/15)
Department of “Huh!?!?”: QE Has Retarded Business Investment!? Washington Center for Equitable Growth, Brad DeLong (27/10/15)
LARRY SUMMERS: The Wall Street Journal published the ‘single most confused analysis’ of the Fed I’ve read this year Business Insider, Myles Udland (29/10/15)
The Fed’s Loose Money, Financial Markets and Business Investment SBE Council, Raymond J. Keating (29/10/15)
How the QE trillions missed their mark AFR Weekend, Maximilian Walsh (4/11/15)
Financial Markets In The Era Of Bubble Finance – Irreversibly Broken And Dysfunctional David Stockman’s Contra Corner, Doug Noland (8/11/15)

Questions

  1. Go through the arguments of Spence and Warsh and explain them.
  2. Explain what are meant by the ‘yield curve’ and ‘zero bound yield curve’.
  3. What criticisms of their arguments are made by Summers and others?
  4. Apart from the effects of QE, why else have long-term interest rates been low?
  5. In the light of the arguments on both sides, how effective do you feel that QE has been?
  6. How could QE have been made more effective?
  7. What is likely to happen to financial markets over the coming months? What effect is this likely to have on the real economy?
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ECB signals further monetary easing

Mario Draghi, the ECB President, has indicated that the ECB is prepared to engage in further monetary stimulus. This is because of continuing weaknesses in the global economy and in particular in emerging markets.

Although the ECB at its meeting in Malta on 22 October decided to keep both interest rates and asset purchases (€60 billion per month) at current levels, Mario Draghi stated at the press conference that, at its next meeting on December 3rd, the ECB would be prepared to cut interest rates and re-examine the size, composition and duration of its quantitative easing programme. He stopped short, however, of saying that interest rates would definitely be cut or quantitative easing definitely increased. He said the following:

“The Governing Council has been closely monitoring incoming information since our meeting in early September. While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation. Most notably, the strength and persistence of the factors that are currently slowing the return of inflation to levels below, but close to, 2% in the medium term require thorough analysis.

In this context, the degree of monetary policy accommodation will need to be re-examined at our December monetary policy meeting, when the new Eurosystem staff macroeconomic projections will be available. The Governing Council is willing and able to act by using all the instruments available within its mandate if warranted in order to maintain an appropriate degree of monetary accommodation.”

Mario Draghi also argued that monetary policy should be supported by fiscal policy and structural policies (mirroring Japan’s three arrows). Structural policies should include actions to improve the business environment, including the provision of an adequate public infrastructure. This is vital to “increase productive investment, boost job creation and raise productivity”.

As far as fiscal policies are concerned, these “should support the economic recovery, while remaining in compliance with the EU’s fiscal rules”. In other words, fiscal policy should be expansionary, while staying within the limits set by the Stability and Growth Pact.

His words had immediate effects in markets. Eurozone government bond yields dropped to record lows and the euro depreciated 3% against the US dollar over the following 24 hours.

Webcasts
ECB Press Conference on YouTube, Mario Draghi (22/10/15)
Draghi reloads bazooka FT Markets, Ferdinando Guigliano (22/10/15)

Articles
Mario Draghi: ECB prepared to cut interest rates and expand QE The Guardian, Heather Stewart (22/10/15)
Draghi signals ECB ready to extend QE Financial Times, Claire Jones and Elaine Moore (22/10/15)
Dovish Mario Draghi sends bond yields to new lows Financial Times, Katie Martin (23/10/15)
What Draghi Said on QE, Policy Outlook, Global Risks and Inflation Bloomberg, Deborah Hyde (22/10/15)
ECB set to ‘re-examine’ stimulus policy at next meeting BBC News (22/10/15)
The global economy warrants a big dose of caution The Guardian, Larry Elliott (25/10/15)

ECB Press Conference
Introductory statement to the press conference (with Q&A) ECB, Mario Draghi (President of the ECB), Vítor Constâncio (Vice-President of the ECB) (22/10/15)

Questions

  1. Why is the ECB considering further expansionary monetary policy?
  2. What monetary measures can a central bank use to stimulate aggregate demand?
  3. Explain the effects of Mario Draghi’s announcement on bond and foreign exchange markets.
  4. What are the objectives of ECB monetary policy according to the its mandate?
  5. Should the ECB consider using quantitative easing to provide direct funding for infrastructure projects?
  6. What constraints does the EU’s Stability and Growth Pact impose on eurozone countries?
  7. What are the arguments for and against (a) the Bank of England and (b) the US Federal Reserve engaging in further QE?
  8. If the ECB does engage in an expanded QE programme, what will determine its effectiveness?
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People’s quantitative easing

Jeremy Corbyn, the newly elected leader of the Labour Party, is proposing a number of radical economic policies. One that has attracted considerable attention is for a new form of QE, which has been dubbed ‘people’s quantitative easing’.

This would involve newly created money by the Bank of England being directly used to fund spending on large-scale housing, energy, transport and digital projects. Rather than the new money being used to purchase assets, as has been the case up to now, with the effect filtering only indirectly into aggregate demand and even more indirectly into aggregate supply, under the proposed scheme, both aggregate demand and aggregate supply would be directly boosted.

Although ‘conventional’ QE has worked to some extent, the effects have been uneven. Asset holders and those with large debts, such as mortgages, have made large gains from higher asset prices and lower interest rates. By contrast, savers in bank and building society accounts have seen the income from their savings decline dramatically. What is more, the indirect nature of the effects has meant time lags and uncertainty over the magnitude of the effects.

But despite the obvious attractiveness of the proposals, they have attracted considerable criticism. Some of these are from a political perspective, with commentators from the right arguing against an expansion of the state. Other criticisms focus on the operation and magnitude of the proposals

One is that it would change the relationship between the Bank of England and the government. If the Bank of England created money to fund government projects, that would reduce or even eliminate the independence of the Bank. Independence has generally been seen as desirable to prevent manipulation of the central bank by the government for short-term political gain. Those in favour of people’s QE argue that the money would be directed into a National Investment Bank, which would then make the investment allocation decisions. The central bank would still be independent in deciding the amount of QE.

This leads to the second criticism and that is about whether further QE is necessary at the current time. Critics argue that while QE of whatever type was justified when the economy was in recession and struggling to recover, now would be the wrong time for further stimulus. Indeed, it could be highly inflationary. The economy is currently expanding. If banks respond by increasing credit, the velocity of circulation of narrow money could rise and broad money supply grow, providing enough money to underpin a growing economy.

Many advocates of people’s QE accept this second point and see it as a contingency plan in case the economy fails to recover and further monetary stimulus is deemed necessary. If further QE is not felt necessary by the Bank of England, then the National Investment Bank could fund investment through conventional borrowing.

The following articles examine people’s QE and look at its merits and dangers. Given the proposal’s political context, several of the articles approach the issue from a very specific political perspective. Try to separate the economic analysis in the articles from their political bias.

Jeremy Corbyn’s proposal
The Economy in 2020 Jeremy Corbyn (22/7/15)

Articles
People’s quantitative easing — no magic Financial Times, Chris Giles (13/8/15)
How Green Infrastructure Quantitative Easing would work Tax Research UK, Richard Murphy (12/3/15)
What is QE for the people? Money Week, Simon Wilson (22/8/15)
QE or not QE? A slippery slope to breaking the Bank EconomicsUK.com, David Smith (23/8/15)
We don’t need “People’s QE”, basic economic literacy is enough Red Box, Jonathan Portes (13/8/15)
Is Jeremy Corbyn’s policy of ‘quantitative easing for people’ feasible? The Guardian, Larry Elliott (14/8/15)
Corbynomics: Quantitative Easing for People (PQE) Huffington Post, Adnan Al-Daini (7/9/15)
Corbyn’s “People’s QE” could actually be a decent idea FT Alphaville, Matthew C. Klein (6/8/15)
Jeremy Corbyn’s ‘People’s QE’ would force Britain into three-year battle with the EU The Telegraph, Peter Spence (15/8/15)
Would Corbyn’s ‘QE for people’ float or sink Britain? BBC News, Robert Peston (12/8/15)
Strategic Quantitative Easing – public money for public benefit New Economics Foundation blog, Josh Ryan-Collins (12/8/15)
People’s QE and Corbyn’s QE Mainly Macro blog, Simon Wren-Lewis
You can print money, so long as it’s not for the people The Guardian, Zoe Williams (4/10/15)

Questions

  1. What is meant by ‘helicopter money’? How does it differ from quantitative easing as practised up to now?
  2. Is people’s QE the same as helicopter money?
  3. Can people’s QE take place alongside an independent Bank of England?
  4. What is meant by the velocity of circulation of money? What happened to the velocity of circulation following the financial crisis?
  5. How does conventional QE feed through into aggregate demand?
  6. Under what circumstances would people’s QE be inflationary?
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The ECB takes the plunge – at last

After promises made back in July 2012 that the ECB will ‘do whatever it takes’ to protect the eurozone economy, the ECB has at last done just that. It has launched a large-scale quantitative easing programme. It will create new money to buy €60 billion of assets every month in the secondary market.

Around €10 billion will be private-sector securities that are currently being purchased under the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year. The remaining €50 billion will be public-sector assets, mainly bonds of governments in the eurozone. This extended programme of asset purchases will begin in March this year and continue until at least September 2016, bringing the total of asset purchased by that time to over €1.1 trillion.

The ECB has taken several steps towards full QE over the past few months, including €400 billion of targeted long-term lending to banks, cutting interest rates to virtually zero (and below zero for the deposit rate) and the outright purchase of private-sector assets. But all these previous moves failed to convince markets that they would be enough to stimulate recovery and stave off deflation. Hence the calls for full quantitative easing became louder and it was widely anticipated that the ECB would finally embark on the purchase of government bonds – in other words, would finally adopt a programme of QE similar to those adopted in the USA (from 2008), the UK (from 2009) and Japan (from 2010).

Rather than the ECB buying the government bonds centrally, each of the 19 national central banks (NCBs), which together with the ECB constitute the Eurosystem, will buy their own nation’s bonds. The amount they will buy will depend on their capital subscriptions the eurozone. For example, the German central bank will buy German bonds amounting to 25.6% of the total bonds purchased by national central banks. France’s share will be 20.1% (i.e. French bonds constituting 20.1% of the total), Spain’s share will be 12.6% and Malta’s just 0.09%.

Central banks of countries that are still in bail-out programmes will not be eligible to purchase their countries’ assets while their compliance with the terms of the bailout is under review (as is the case currently with Greece).

The risk of government default on their bonds will be largely (80%) covered by the individual countries’ central banks, not by the central banks collectively. Only 20% of bond purchases will be subject to risk sharing between member states according to their capital subscription percentages: the ECB will directly purchase 8% of government bonds and 12% will be bonds issued by European institutions rather than countries. As the ECB explains it:

With regard to the sharing of hypothetical losses, the Governing Council decided that purchases of securities of European institutions (which will be 12% of the additional asset purchases, and which will be purchased by NCBs) will be subject to loss sharing. The rest of the NCBs’ additional asset purchases will not be subject to loss sharing. The ECB will hold 8% of the additional asset purchases. This implies that 20% of the additional asset purchases will be subject to a regime of risk sharing.

As with the QE programmes in the USA, the UK and Japan, the transmission mechanism is indirect. The assets purchased will be from financial institutions, who will thus receive the new money. The bond purchases and the purchases of assets by financial institutions with the acquired new money will drive up asset prices and hence drive down long-term interest rates. This, hopefully, will stimulate borrowing and increase aggregate demand and hence output, employment and prices.

The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money, which the institutions that sold the securities can use to buy other assets and extend credit to the real economy. In both cases, this contributes to an easing of financial conditions.

In addition, there is an exchange rate transmission mechanism. To the extent that the extra money is used to purchase non-eurozone assets, so this will drive down the euro exchange rate. This, in turn, will boost the demand for eurozone exports and reduce the demand for imports to the eurozone. This, again, represents an increase in aggregate demand.

The extent to which people will borrow more depends, of course, on confidence that the eurozone economy will expand. So far, the response of markets suggests that such confidence will be there. But we shall have to wait to see if the confidence is sustained.

But even if QE does succeed in stimulating aggregate demand, there remains the question of the competitiveness of eurozone economies. Some people are worried, especially in Germany, that the boost given by QE will reduce the pressure on countries to engage in structural reforms – reforms that some people feel are vital for long-term growth in the eurozone

The articles consider the responses to QE and assess its likely impact.

Articles
The ECB makes its mind up: The launch of euro-style QE The Economist (22/1/15)
ECB unveils massive QE boost for eurozone BBC News (22/1/15)
Eurozone boost of €1.1tn in ‘shock and awe’ plan by Central Bank The Guardian, Heather Stewart (22/1/15)
European Central Bank unleashes quantitative easing Financial Times, Claire Jones (22/1/15)
11 questions you are too embarrassed to ask about Quantitative Easing Independent, Russell Lynch (22/1/15)
What the experts say about the ECB’s latest round of QE The Guardian, Julia Kollewe (22/1/15)
Mario Draghi’s QE blitz may save southern Europe, but at the risk of losing Germany The Telegraph, Ambrose Evans-Pritchard (22/1/15)
The sad consequences of the fear of QE The Economist, Paul De Grauwe (21/1/15)
Will euro QE work? BBC News, Robert Peston (20/1/15)

ECB publications
ECB announces expanded asset purchase programme ECB Press Release (22/1/15)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi, President of the ECB (22/1/15)
Webcast of ECB press conference, Mario Draghi, President of the ECB (22/1/15)

Previous blog posts
The fate of the eurozone (7/1/15)
Eurozone deflation risk (1/12/14)
Edging closer to full QE (6/9/14)
The ECB: tackling the threat of deflation (8/6/14)

Data
Euro area economic and financial data ECB

Questions

  1. Why has the ECB been reluctant to engage in full QE before now?
  2. How has the ECB answered the objections of strong eurozone countries, such as Germany, to taking on the risks associated with weaker countries?
  3. What determines the amount by which aggregate demand will rise following a programme of asset purchases?
  4. In what ways and to what extent will non-eurozone countries benefit or lose from the ECB’s decision?
  5. Are there any long-term dangers to the eurozone economy of the ECB’s QE programme? If so, how might they be tackled?
  6. Why did the euro plummet on the ECB’s announcement? Why had it not plummeted before the announcement, given that the introduction of full QE was widely expected?
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All eased out: at least for the USA and UK

Following the recession of 2008/9, the UK has engaged in four rounds of quantitative easing (QE) – the process whereby the central bank increases the money supply by purchasing government bonds, and possibly other assets, on the open market from various institutions. The final round was announced in July 2012, bringing the total assets purchased to £375bn. As yet, however, there are no plans for quantitative tightening – the process of the Bank of England selling some of these assets, thereby reducing money supply.

The aim of QE has been to stimulate aggregate demand. Critics claim, however, that the effect on spending has been limited, since the money has not gone directly to consumers but rather to the institutions selling the assets, who have used much of the money to buy shares, bonds and other assets. Nevertheless, with banks having to strengthen their capital base following the financial crisis, QE has helped then to achieve this without having to make even bigger reductions in lending.

The Bank of England now reckons that the recovery is sufficiently established and there is, therefore, no need for further QE.

This is also the judgement of the Federal Reserve about the US economy, which experienced annual growth of 3.5% in the third quarter of 2014. The IMF predicts that US growth will be around 3% for the next three years.

The Fed has had three rounds of QE since the financial crisis, but in October 2014 called an end to the process. Since the start of this year, it has been gradually reducing the amount it injects each month from $85bn to $15bn. The total bond purchases over the past five years have been some $3.6tn, bringing the Fed’s balance sheet to nearly $4.5tn.

But as QE comes to an end in the USA, Japan is expanding its programme. On 31 October, the Bank of Japan announced that it would increase its asset purchases from ¥60-70tn per year to ¥80tn (£440bn). The Japanese government and central bank are determined to boost economic growth in Japan and escape the two decades of deflation and stagnation. The Tokyo stock market rose by some 8% in the week following the announcement and the yen fell by more than 5% against the dollar.

And the European Central Bank, which has not used full QE up to now, looks as if it is moving in that direction. In October, it began a programme of buying asset-backed securities (ABSs) and covered bonds (CBs). These are both private-sector securities: ABSs are claims against non-financial companies in the eurozone and CBs are issued by eurozone banks and other financial institutions.

It now looks as if the ECB might take the final step of purchasing government bonds. This is probably what is implied by ECB President Mario Draghi’s statement after the 6 November meeting of the ECB that the ground was being prepared for “further measures to be implemented, if needed”.

But has QE been as successful as its proponents would claim? Is it the solution now to a languishing eurozone economy? The following articles look at these questions.

Fed calls time on QE in the US – charts and analysis The Guardian, Angela Monaghan (29/10/14)
Quantitative easing: giving cash to the public would have been more effective The Guardian, Larry Elliott (29/10/14)
End of QE is whimper not bang BBC News, Robert Peston (29/10/14)
Federal Reserve ends QE The Telegraph, Katherine Rushton (29/10/14)
Bank of Japan to inject 80 trillion yen into its economy The Guardian, Angela Monaghan and Graeme Wearden (31/10/14)
Every man for himself The Economist, Buttonwood column (8/11/14)
Why Japan Surprised the World with its Quantitative Easing Announcement Townhall, Nicholas Vardy (7/11/14)
Bank of Japan QE “Treat” Is a Massive Global Trick Money Morning, Shah Gilani (31/10/14)
ECB stimulus may lack desired scale, QE an option – sources Reuters, Paul Carrel and John O’Donnell (27/10/14)
ECB door remains open to quantitative easing despite doubts over impact Reuters, Eva Taylor and Paul Taylor (9/11/14)
ECB could pump €1tn into eurozone in fresh round of quantitative easing The Guardian,
Angela Monaghan and Phillip Inman (6/11/14)
Ben Bernanke: Quantitative easing will be difficult for the ECB CNBC, Jeff Cox (5/11/14)
Not All QE Is Created Equal as U.S. Outpunches ECB-BOJ Bloomberg, Simon Kennedy (6/11/14)
A QE proposal for Europe’s crisis The Economist, Yanis Varoufakis (7/11/14)
UK, Japan and 1% inflation BBC News, Linda Yueh (12/11/14)
Greenspan Sees Turmoil Ahead As QE Market Boost Unwinds Bloomberg TV, Gillian Tett interviews Alan Greenspan (29/10/14)

Questions

  1. What is the transmission mechanism between central bank purchases of assets and aggregate demand?
  2. Under what circumstances might the effect of a given amount of QE on aggregate demand be relatively small?
  3. What dangers are associated with QE?
  4. What determines the likely effect on inflation of QE?
  5. What has been the effect of QE in developed countries on the economies of developing countries? Has this been desirable for the global economy?
  6. Have businesses benefited from QE? If so, how? If not, why not?
  7. What has been the effect of QE on the housing market (a) in the USA; (b) in the UK?
  8. Why has QE not been ‘proper’ money creation?
  9. What effect has QE had on credit creation? How and why has it differed between the USA and UK?
  10. Why did the announcement of further QE by the Bank of Japan lead to a depreciation of the yen? What effect is this depreciation likely to have?
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Edging closer to full QE

As we saw in the blog post last month, Eurozone becalmed the doldrums, the eurozone economy is stagnant and there is a growing danger that it could sink into a deflationary spiral. Last month, several new measures were announced by the ECB, including a negative interest rate on money deposited in the ECB by banks in the eurozone. This month, the ECB has gone further including, for the first time, a form of quantitative easing.

So what has been announced, and will it help to kick-start the eurozone economy? The measures were summarised by Mario Draghi, President of the ECB, at a press conference as follows:

The Governing Council decided today to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.05% and the rate on the marginal lending facility by 10 basis points to 0.30%. The rate on the deposit facility was lowered by 10 basis points to –0.20%. In addition, the Governing Council decided to start purchasing non-financial private sector assets.

The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme (CBPP3). Interventions under these programmes will start in October 2014.

To summarise: the ECB has cut interest rates, with the main rate cut to virtually zero (i.e. 0.05%). This represents a floor to interest rates, as, according to Mario Draghi, there is now no scope for further cuts. (Click here for a PowerPoint of the chart.)

In addition, the ECB will begin the outright purchase of private-sector securities. This is a form of quantitative easing as it will involve the purchase of assets with newly created money. In the past, the ECB has simply offered loans to banks, with assets owned by banks used as collateral. This form of quantitative easing has been dubbed ‘QE light’, as it does not involve the purchase of government bonds, something the German government in particular has resisted. The ECB recognises that it would be a sensitive matter to buy government bonds of countries, such as Greece, Spain and Cyprus, which have been criticised for excessive borrowing.

Nevertheless, if it involves the creation of new money, purchasing private-sector assets is indeed a form of QE. As Mario Draghi said in response to a question on this matter:

QE is an outright purchase of assets. To give an example: rather than accepting these assets as collateral for lending, the ECB would outright purchase these assets. That’s QE. It would inject money into the system. Now, QE can be private-sector asset-based, or also sovereign-sector, public-sector asset-based, or both. The components of today’s measures are predominantly oriented to credit easing. However, it’s quite clear that we would buy outright ABS only if there is a guarantee.

So with appropriate guarantees in place about the soundness of these securitised assets, the ECB will purchase them outright.

But will these measures be enough? Time will tell, but there are now several measures in the pipeline, which could see a large stimulus to bank lending. The main question is whether banks will indeed take the opportunity to lend or merely hoard the extra reserves. And that depends in large part on the demand for credit from businesses and consumers. Boosting that is difficult when the economic climate is pessimistic.

Articles
Draghi’s ECB surprise puts off bigger quantitative easing for now Reuters, John O’Donnell (5/9/14)
ECB President Mario Draghi pulls stimulus lever at last, but still no quantitative easing for eurozone Independent, Ben Chu (5/9/14)
ECB cuts rates and launches stimulus programme BBC News (4/9/14)
Draghi Push for ECB Easing Intensifies Focus on ABS Plan Bloomberg, Stefan Riecher and Jeff Black (4/9/14)
Draghi Sees Almost $1 Trillion Stimulus as QE Fight Waits Bloomberg, Simon Kennedy (5/9/14)
Draghi’s Case For ECB Quantitative Easing Forbes, Jon Hartley (8/9/14)
ECB’s last roll of the dice BBC News, Robert Peston (4/9/14)
Draghi’s eurozone steroids BBC News, Robert Peston (2/10/14)
Draghinomics – Abenomics, European-style The Guardian, Nouriel Roubini (1/9/14)

ECB Press Release
Introductory statement to the press conference (with Q&A) European Central Bank, Mario Draghi, President of the ECB (4/9/14)
Webcast of the press conference 4 September 2014 European Central Bank, Mario Draghi, President of the ECB (4/9/14)

Questions

  1. Summarise the ECB’s monetary policy measures that will be coming into effect over the coming months.
  2. How does the QE announced by Mario Draghi differ from the QE that has been used by the Bank of England?
  3. Would it be a realistic option for the ECB to reduce its main rate below zero, just as it did with the deposit facility rate?
  4. What is meant by ‘securitisation’. Explain how asset-backed securities (ABSs) and covered bonds are forms of securitised assets.
  5. Why will the purchase of mortgage-backed securities not necessarily give a boost to the housing market?
  6. How does the effectiveness of any QE programme depend on what happens to the velocity of circulation of created money?
  7. What determines this velocity of circulation?
  8. Why are ‘animal spirits’ so important in determining the effectiveness of monetary policy?
  9. Are there any moral hazards in the ECB actions? If so what are they?
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Doves from above

With many countries struggling to recover from the depression of the past few years, central banks are considering more and more doveish moves to kick-start lending. But with short-term interest rates in the USA, the UK and Japan close to zero, the scope for further cuts are limited. So what can central banks do?

The first thing that can be done is to adopt a higher inflation target or to accept inflation above target – at least for the time being. This could be accompanied by explicitly targeting GDP growth (real or nominal) or unemployment (see the blog from last December, Rethinking central bank targets).

The second option is to increase quantitative easing. Although in a minority at the last MPC meeting, Mervyn King, the current Bank of England Governor, argued for a further £25 billion of asset purchases (bringing the total to £400bn) (see MPC minutes paragraph 39). It is highly likely that the MPC will agree to further QE at its next meeting in March. In Japan, the new governor of the Bank of Japan is expected to include asset purchases as part of the policy of monetary easing.

The third option is for the central bank to provide finance at below-market rates of interest directly to the banking sector specifically for lending: e.g. to small businesses or for house purchase. The Bank of England’s Funding for Lending Scheme is an example and the Bank is considering extending it to other financial institutions.

One other approach, mooted by the Bank of England’s Deputy Governor before the House of Commons Treasury Select Committee, is for negative interest rates paid on Banks’ reserves in the Bank of England. This would, in effect, be a fee levied on banks for keeping money on deposit. The idea would be to encourage banks to lend the money and not to keep excessive liquidity. As you can see from the chart, three rounds of quantitative easing have led to a huge increase in bank’s reserves at the Bank of England. (Click here for a PowerPoint of the chart.)

The following articles consider these various proposals and whether they will work to stimulate lending and thereby aggregate demand and economic recovery.

Central banks: Brave new words The Economist (23/2/13)
Phoney currency wars The Economist (16/2/13)
Analysis: Global central banks will keep taking it easy Reuters, Alan Wheatley (22/2/13)
Quantitative easing: the markets are struggling with a serious drug habi The Guardian, Larry Elliott (24/2/13)
Negative interest rates idea floated by Bank’s Paul Tucker BBC News (26/2/13)
Bank of England mulls negative interest rates Independent, Ben Chu (26/2/13)
BoE floats extending Funding for Lending to non-banks Mortgage Solutions, Adam Williams (26/2/13)
Funding for Lending Scheme failing to get banks lending Left Foot Forward, James Bloodworth (26/2/13)
Mortgage market boosted by lending schemes, says Redrow BBC News (26/2/13)
Widespread quantitative easing risks ‘QE wars’ and stagnation The Guardian, Nouriel Roubini (28/2/13)

Questions

  1. Consider each of the methods outlined above and their chances of success in stimulating aggregate demand.
  2. Go through each of the methods and consider the problems they are likely to create/have created.
  3. How important is it that monetary policy measures affect people’s expectations?
  4. What effects do the measures have on the distribution of income between borrowers and savers?
  5. What are annuities? How are these affected by policies of monetary easing?
  6. How has actual and anticipated Japanese monetary policy affected the exchange rate of the Japanese yen? How is this likely to affect the Japanese economy?
  7. Explain the sub-heading of the final article above, “When several major central banks pursue QE at the same time, it becomes a zero-sum game”. Do you agree?
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