Quantitative Easing In Focus

Yet Another Trefis Post On Economic Issues of Note

Quantitative Easing In Focus

In the aftermath of the global financial crisis, the Federal Reserve resorted to a type of monetary policy called Quantitative Easing (QE) in order to revive the U.S. economy. This program, which involves buying securities, with the aim of lowering interest rates and injecting liquidity into the economy, has often been referred to as being somewhat “unconventional.”  However, in recent times, QE has hardly been unconventional, with a number of central banks, such as the Bank of Japan (BOJ), and more recently the European Central Bank (ECB) also jumping on the bandwagon. This article covers a simple model of interest rate determination, which is used to understand how QE works. We then highlight some risks that could be involved with the use of the policy.

The Dynamics In Interest Rate Determination

Let’s start by looking at how interest rates are determined. At a very basic level, individuals make decisions regarding how to allocate their wealth, i.e. they decide how much of their wealth they should hold as cash and how much they should hold as bonds, or any interest paying asset. This decision comes since there exists a trade off. In particular, money buys goods and services, but it does not earn interest. Bonds on the other hand, earn interest but cannot buy goods and services. This forms the basis of the existence of two distinct markets — one for money and one for bonds. The interaction between market forces (demand and supply) is what ultimately decides what is called the equilibrium interest rate.

Let’s look at the money market first. In the money market, economic agents demand money, which is essentially a function of the price level, income level, and interest rates. In general, money demand increases when prices and incomes increase. This is because when prices increase the cost of acquiring goods go up, and when incomes increase, people’s demand for goods and services go up, both of which motivates agents to hold more wealth in the form of cash. On the other hand, money demand decreases when interest rates increase since the yield on bonds is now higher, which motivates agents to hold more wealth in the form of bonds. Money supply on the other hand, is exogenously determined, in that it is set by the central bank. A similar mechanism is at work even in the bond market. Here, the demand for bonds is positively related to interest rates, since a higher interest rate increases the opportunity cost of holding money. Bond supply is also exogenously determined by the central bank. The equilibrium interest rate is determined where the money market and the bond market stabilizes, i.e. where demand equals supply in both markets.

Typically, monetary policy involves central banks controlling short-term interest rates or the overnight rate. Central banks do this by making sure that the banking system is routinely short of liquidity. This is done by altering reserve requirements, or through open market sale or purchases. Hence, every now and then the banking system has to borrow funds from the central banks. The central bank then sets the rate at which it would supply funds to the banks, which then goes on to determine other market interest rates. However, in some cases, the central bank’s lending rate to banks may fall very close to zero, such that the rate cannot be lowered any further. Note, that if interest rates fall to zero, then economic agents will just prefer to hold their wealth only in the form of cash, which could completely drain bank deposits and reduce credit supply. However, at the same time, the point of full employment and price stability may require interest rates to remain below zero. This is when unconventional monetary policy, such as QE, comes in.

Quantitative Easing In Perspective

QE refers to a form of monetary policy, where the Central Bank purchases securities, such as government bonds, with the aim of reducing interest rates and increasing money supply to stir growth. So let’s break this down, in relation to the U.S.

When the Fed started pursuing QE, they essentially started purchasing bonds from commercial banks. This, in turn, increased the bank’s reserves by the amount of assets that the Central Bank has purchased. Note that this cash did not exist before and is created electronically for this purpose. Going back to our framework, this step has essentially increased money supply in the money market and pulled back bond supply in the bond market. Hence, at the prevailing interest rates, there is a disequilibrium — i.e. supply exceeds demand in the money market, and supply is short of demand in the bond market. So essentially now, economic agents are forced to hold more cash than they are willing to, and fewer bonds than they would have liked to, at the prevailing interest rates. So, the logical thing to do is to buy more bonds, to replace the ones sold, with the new money that they have received. But when agents start demanding more bonds, the price of bonds start increasing, which consequently reduces the yield on the bond. Hence, a new equilibrium interest rate is reached, which is lower than what it was previously. This lower interest rate encourages borrowing and investments, to spur economic growth.

QE And Its Associated Risks

In general, every policy comes with a tradeoff, and QE is no exception to this. There are several risks associated with QE.

— First and foremost, it is hard to judge how much of QE is correct. Clearly, if QE involves injecting liquidity into the economy, it runs the risk of increasing inflation. Furthermore, when any Central Bank announces any monetary policy, it changes inflationary expectations, and when it involves an unconventional monetary policy, it could severely destabilize inflationary expectations. In this case, the monetary authority might be confronted with the growth versus inflation tradeoff at some point.

— Second, pursuing QE can distort investor’s valuation of other assets in their portfolios. This is because, QE essentially reduces the risk-free rate, which is a yardstick for measuring the risks on other assets. Hence, QE ends up distorting the value of other financial instruments such as stocks, credit instruments, etc., which could hamper investment decisions.

— Third, given the degree of global interconnectedness, QE in one economy extends its impact on other economies, through various channels. Once again, the role of expectations come to the forefront, where investors move their funds to those markets where they anticipate higher returns. When the U.S. started pursuing QE, capital flow went out of the U.S. to emerging markets in anticipation of higher returns. More recently, after the U.S. announced a QE taper, capital started returning to the U.S. leaving emerging economies in a tailspin.

— Fourth, given that QE tends to exert an impact on other economies as well, it tends to alter exchange rates. In particular, QE tends to weaken currency. However, if many central banks simultaneously start pursuing QE, the policy essentially becomes moot. This is because, not all countries can be net exporters. In this case, the policy essentially becomes what is known as a zero-sum game, where one nation’s gain is equivalently matched by another nation’s loss.

— Finally, there are risks associated with when to exit QE. Clearly, this is an artificially created stimulus and has to be abandoned at an appropriate time. In this case, it can be difficult to judge whether this exit decision ought to be made on the basis of the present state of the economy or based on the forecasted state. In case of a premature exit, the economy’s growth rates might be affected, and if the policy is overused, factors such as inflation could hurt the economy.

In conclusion, this article mainly aims at explaining how QE works and some risks that are associated with it. Powerful monetary policies such as QE have widespread implications in business and finance, especially when major economies start pursuing the policy. While the explanation above is rather stylized, in the sense that in practice QE can have more far reaching consequences than what is predicted in theory, it forms a useful basis to understand the global economy as we know it today. In a follow-up article, we will examine the U.S. experience with the policy, along with how effective it has been in reviving the economy.

Sources:

1. What is quantitative easing?
2. Widespread quantitative easing risks ‘QE wars’ and stagnation
3. Coming soon?
4. The effects and risks of quantitative easing
5. Four Stories of Quantitative Easing

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