03 Nov 2015Quantitative Easing – An Insight
Quantitative Easing can be defined as a type of unconventional monetary policy whereby the central bank controls money supply within the economy through purchase and sale of financial assets from commercial banks and various other financial institutions. It intends to stimulate economic growth at the time of recession and stabilize high inflation periods when the conventional models does not seem effective.
The conventional policy involves controlling the money supply through increasing or decreasing the target interest rate, open market operations and affecting the bank reserve limits. However, in periods of extreme crisis the conventional methods might be ineffective and quantitative easing as an unconventional method might act as a savior. Under the conventional method the central bank influences the short term risk free rates, but the method might not work if the short term interest rates are near zero. In such a situation the central bank injects money supply through quantitative easing by affecting the risk and the term premiums charged in the market. The central bank starts buying long term government securities thereby bringing down the long term interest rates and thus affecting the term premium. Alternatively, it buys private debt, thereby reducing the interest rate on these debts and the risk premium.
United States and Japan –An Example
During the global financial meltdown of 2007-08, US Federal Reserve adopted quantitative easing as an alternative policy to revive the economy. At the end of 2008 the Federal Reserve brought the short term rates near to zero but the economy continued to worsen. So, the Fed started to buy huge quantities of long term securities that pushed the security prices upward and the interest rates downwards.
The policy was implemented in three distinct phases as QE 1, QE 2 and QE 3. During QE1, the Federal Reserve had increased its holdings in mortgage-backed securities, Treasury securities and agency from $584 Billion on March 11, 2009 to $2,012 Billion by March 24, 2010. On October 27, 2010 the holdings denoted a figure of $2,033 Billion. In November 2010 Federal Reserve announced another round of quantitative easing QE 2 and by June 22 of 2011 the holdings rose to $2,626 billion. After another pause, the Federal Reserve announced the third round of quantitative easing, QE 3 from September 13, 2012. During QE 3, due to large-scale purchases the net holdings increased on average by $20 Billion a week. Contingent upon the continued positive economic data, on June 19, 2013 the Federal Reserve announced the “tapering” of some of its QE policies. Measuring the impact of the policy has not been that straightforward. Though the supporters say that the QE policy did work and kept the interest rates low for households and firms, created new jobs and saved the economy from another great depression on the flipside the critics suggested that it could lead another financial crisis and raging inflation. The figure above shows security holdings of Federal Reserve during the process.
Japan in 2001 also took the unconventional way and adopted quantitative easing as a policy to increase the growth and fight deflation. However, the nation failed to revive the economy. In April 2013, Bank of Japan announced the beginning of another QE programme worth $ 1.4 Trillion. It was a part of a set of policies known as Abenomics. Under the policy, Bank of Japan decided to enforce quantitative easing through buying government bonds worth 7 trillion yen each month using electronically created money. However, seeing the low inflation, Bank of Japan further announced the expansion of already massive QE by increasing the amount pushed in the system to 80 trillion yen from 60-70 trillion yen previously.
Comparing these two interventions, Japan implement the QE policy by affecting the long term risk free rate and thus the term premium and on the other side US implemented the policy by affecting the long term interest rates on risky assets and thus affecting the risk premium.
Issues and Limitations
Every policy comes with its own pros and cons. Listed below are some of the limitations and issues that nations face while using QE as a recovery policy:-
• After implementing the QE policy, the central banks are left with huge amounts of financial assets and selling these assets could be a tough decision as it might reduce the money supply in the economy. Hence, exiting from this strategy might also raise a question, as exiting too early could hamper the recovery process and exiting too late might present inflation as a problem.
• QE involves buying and selling the assets from commercial banks and financial institutions. However, in periods of financial crisis the banks and financial institutions might be reluctant to provide loans further to the households or the firms, which might not lead to increase in money supply at the times of recession thus making the QE policy ineffective.
• Another big concern is excessive inflation. As more money is circulated within the economy the money supply increases however, the supply of goods remains the same. This might lead to increasing the competition for good, which in turn could lead to increased prices and thus higher inflation. Consequently the economy might operate inefficiently.
To conclude, Quantitative easing is an unconventional policy that comes into the picture when the conventional monetary policies are ineffective. However, the effect of quantitative easing can be both positive and negative. Some of the elements of the policy will present its usefulness in reviving the economy and some might present a new and unique challenge for the central bank.