Quantitative Easing
Loosening monetary policy could be said to
help countries move out of a recession. Usually, the Central Bank would lower
interest rates in order to stimulate consumer spending, as consumers would then
have a greater incentive to borrow more money, and a disincentive to save their
money. However, when nominal interest rates are almost at 0, and domestic
demand fails to increase, unconventional measures may need to be used, in order
to pull the economy out of the liquidity trap. In the wake of the recent
Financial Crisis, the Bank of England’s unconventional weapon of choice was
Quantitative Easing. This was instigated in order to increase liquidity and reduce long term interest rates, and so stimulate
consumer spending because, as Mervyn King stated at the time, interest rates
and fiscal stimulus did not increase consumer demand. Indeed, monetary policy
would be much easier and quicker to implement than a fiscal stimulus. Did
Quantitative Easing help the Bank meet its 2pc inflation target? Did it help
reduce the impact of the financial crisis?
The Mechanism Behind Quantitative Easing
Interest Rates
A Central Bank would create money
electronically, increasing its balance sheet, and so the economy’s monetary
base. It would use this money to buy financial assets, usually government
bonds. This would increase the price of these assets, thus reducing their
yield. Therefore, these financial assets would be less attractive for financial
institutions, and so investors would, rationally, switch to purchasing company
shares and company bonds, which would, relatively, provide a higher yield. This
would result in investment by the company. Moreover, as these financial
institutions switch to purchasing company shares and bonds, the prices of these
financial instruments should increase and the yield should, therefore, decrease.
This is compounded by the fact that the Central Bank is also likely to buy
corporate bonds, thus increasing the demand for corporate bonds even further,
increasing their price and decreasing their yield. Overall, therefore,
long-term interest rates would decrease. This would therefore mean that companies
and households have to pay less interest, increasing the money available for
investment. Investment would also help to create jobs both directly in the
company, but also through sending transmission waves in the economy, through increased
demand for machinery to expand factories, for example. Therefore, as more
people are employed, and wages therefore rise, consumer spending should
increase. Furthermore, higher asset prices would also encourage consumer
spending through the wealth effect. Also, the action of Quantitative Easing may
increase consumer confidence, thus stimulating consumer spending.
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| Figure 2: The effect of QE on asset prices in the UK |
However, it is important to note that lower
yields on government bonds may not result in investors switching to investing
in the stock market, where yields would be higher. This is because in a
recession investors may prefer to invest in government bonds and have a guaranteed
flow of income, rather than invest in high-risk high yield shares, which would
not provide a guaranteed flow of income, especially in a recession.
Figure 2 shows that when the Bank of England
announced its Quantitative Easing programme the price of assets increased,
reversing the decline that they had experienced since 2007. Indeed, over the
whole period of Quantitative Easing, corporate bond yields fell by 70 basis
points.
However, it should be noted that we cannot
know for sure the true extent Quantitative Easing has played in the increase in
asset prices. Indeed, asset prices have increased globally, including in
countries not practicing Quantitative Easing.
Liquidity
Moreover, as the central bank buys assets
from financial institutions, the size of the banks’ balance sheets would
increase, thus increasing their liquidity. Indeed, the Bank of England’s gilt
buying programme trebled the size of banks’ balance sheets relative to GDP. Therefore,
financial institutions had more money and began buying other financial assets,
such as stocks and shares. However, as demand increased, so did their price,
and so yields decreased. Moreover, as well as buying other financial assets,
the financial institutions that sold these assets, as well as other affected
persons, deposited this money in commercial banks. Consequently, this then
resulted in commercial banks’ supply of money increasing, stimulating greater
lending.
However, this effect was small because commercial banks were in the
process of de-leveraging (servicing their existing debt before lending to
customers again). Therefore, although interbank lending rates did decrease
dramatically following the initiation of the Quantitative Easing programme, new
bank lending rates for households and firms did not decrease to such a great
extent to have an impact on consumers’ borrowing.
Inflation
As the money supply is expected to increase,
inflation should increase in line. Indeed, following the initiation of the Bank
of England’s bond-buying programme, inflation stayed above its target of 2pc
for 4 years. This probably helped to increase consumer spending as consumers
realised that prices were expected to increase in the future, and so they
bought ‘now’ rather than waiting. [side note: this is a good way to persuade
your parents to buy you that new designer handbag/pair or shoes etc.]
The Budget Deficit
A pleasant side effect of Quantitative Easing
is that it may also boost government spending. As the Central Bank always
announces its bond buying programmes about a month in advance, this causes
banks to buy government bonds directly, so that the following month they can
sell the bonds to the Central Bank at a higher price than they bought them at,
meaning that they can earn profit. This provides the government would cheap
access to credit. Moreover, the government budget deficit could also be reduced
because inflation could accompany the Quantitative Easing programme, reducing
the value of the debt burden. Quantitative Easing could increase GDP, as
explained above, thus reducing the debt : GDP.
Impact
Kapetanios et al have used econometric models
to model the affect of Quantitative Easing on the level of GDP by stimulating
‘policy’ and ‘no policy’ scenarios.
Through calculations on the wealth of elasticity of consumption, they concluded
that Quantitative Easing increased the GDP by 1.5pc and increased inflation by
1.25pc. However, these figures do vary with the type of econometrical model used
as well as the assumptions taken into consideration, meaning that we must treat
the figures with caution. In Kapetanios et al’s model, the yield of 5- and
10-year gilts was assumed to be 100 basis points higher in the ‘no policy’
scenario than in the ‘policy’ scenario.
Moreover, it has been calculated that
Quantitative Easing had a dramatic impact on the strength of the recovery
relative to the effect that reducing interest rates further, (if it were
possible), would have had. A Bank of England model suggests that the effect
“was equivalent to a 150 to 300 basis point cut in Bank rate”.
Inflation
Indeed, there are problems with creating
money electronically, just as there are problems with turning the Central Bank
into a non-stop printing press. Creating ‘too much’ money could result in the
supply of money increasing too much, thus leading to inflation and even
hyperinflation. However, if the economy is in a liquidity trap, then the new money
may not lead to inflation and it may even help to increase aggregate demand.
However, not enough Quantitative Easing would
mean that interest rates in the economy would not be affected to such a great
extent, failing to stimulate sufficient demand to pull the economy out of a
recession.
Moreover, Quantitative Easing rests on the
confidence of the people. If people believe that Quantitative Easing is not a
credible measure to pull the economy out of a recession, then these people may
not react and increase their spending.
Depreciating the Exchange Rate
As a result of Quantitative Easing, the
currency may devalue, as there is the potential for inflation. However, this
may not necessarily be a negative effect. Indeed, a devalued currency would
mean that exports are relatively cheap in comparison to other countries, and so
demand for exports increases, and this could multiply throughout the economy,
increasing aggregate demand and thus employment.
f(x) = Inverse (Quantitative Easing)
If inflation is expected to increase above
2pc, the bank is likely to sell assets in order to decrease the supply of money,
thus decreasing the price of goods. Moreover, it is also likely to use
conventional methods, such as decreasing the bank base rate in order increase
saving and reduce spending.
Figure 3 highlights a strong positive
correlation between the S&P 500 Index and the Federal Reserve’s balance
sheet. Although correlation does not imply causation, it is likely that when
the Federal Reserve stops Quantitative Easing, stock market prices are
likely to fall, because the Fed would not be providing liquidity to financial
institutions, who buy these bonds. Indeed, when the Fed sells treasury bonds to
the banks, the supply of treasury bonds will increase, their price will
decrease and so yields and interest rates will increase. Even if the Federal
Reserve does not sell all of the bonds at once, interest rates are likely to be
high, in order to persuade the banks to buy the bonds. Due to these high
interest rates on treasury bonds, it is likely that stock prices and home
prices will decrease as a result. Furthermore, as interest rates would be high,
this would make it harder for the government to pay interest.
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| Figure 3: The relationship between the Federal Reserve's Assets and Standard and Poor 500 Index |
As with Quantitative Easing, the Federal
Reserve needs to strike the right balance, in order to ensure that interest
rates do not increase to too high levels, which could therefore result in
deflation. Timing also matters. Should the Central Bank refuse to part with
Quantitative Easing, inflation could ensue when she finally decides to reverse
the process. On the other hand, should Quantitative Easing be disregarded too
early, when the economy is still in a recession, then deflation could follow.
Therefore, the Bank of England and Federal Reserve need to ensure that they
gradually reverse Quantitative Easing and ensure that they do not increase the
supply of government bonds to too high levels.
It seems too good to be true…
Keynesian Economists would argue that
Quantitative Easing would not, and should not, work. As unemployment is high,
although cheap loans would be available to businesses, businesses would be
reluctant to invest because consumer
demand is low. There would be low business confidence and so businesses
would not invest. Therefore, they argue that the government should invest
itself in order to create employment and so stimulate aggregate demand.
It has been estimated that, in the UK alone,
savers have suffered a ‘loss’ of £70bn as a result of Quantitative Easing,
whilst borrowers have ‘gained’ £104 bn. Pensioners have not been best pleased
with the Bank of England’s unconventional programme. Due to lower interest
rates, their monthly pension halved in 2012. They argue that this is unfair
because Quantitative Easing promotes inflation, but their incomes fall, meaning
that their standard of living erodes. However, it should be noted that pensioners
would benefit from increasing share prices, as well as from the increased value
of other assets, such as houses. Moreover,
it should be noted that although Quantitative Easing may have had side effects that
have been perceived as unfair, it has helped to avoid a deep depression, and on
that point it must be commended.
The Evolution of Quantitative Easing
It has been argued that the Bank of England,
rather than purchasing existing bonds, should purchase new bonds from the
government. Those who champion this view argue that the UK government is highly
unlikely to default, because it is solvent.
Moreover, it would hit two birds with one stone: taxes could be cut in
order to stimulate demand through consumer spending, but the government does
not need to change its budget, meaning that British citizens can retain their unemployment
benefits and other fiscal stimulants.
Others are advocating ‘bank bonds’ in order
to stimulate lending by banks, which does not seem to have increased despite Quantitative Easing. They
argue that the Bank of England should buy bonds from commercial banks,
providing liquidity to the banks and so ensuring that they can lend to
businesses and consumers, rather than servicing their debts as has been the
case.
