Unconventional Monetary Policy: Direct Quantitative Easing (4)

KEYNOTE LECTURE AT THE INTERNATIONAL CENTER FOR MONETARY AND BANKING STUDIES (ICMB),
GENEVA, 28 APRIL 2009

How are unconventional measures implemented?

1 Direct Quantitative Easing

2 Direct Credit Easing

3 Indirect (or Endogenous) Quantitative/Credit Easing

1 Direct Quantitative Easing

When the central bank decides to expand the size of its balance sheet, it has to choose which assets to buy. In theory, it could purchase any asset from anybody. In practice, however, quantitative easing has traditionally focused on buying longer-term government bonds from banks. The idea is twofold: first, sovereign yields serve as a benchmark for pricing riskier privately issued securities. When long-term government bonds are purchased, the yields on privately issued securities are expected to decline in parallel with those on government bonds. Second, if long-term interest rates were to fall, this would stimulate longer-term investments and hence aggregate demand, thereby supporting price stability.

This is where banks play a critical role in the success of any quantitative easing policy. If the aim is to ensure that new loans are provided to the private sector, central banks should mainly purchase bonds from the banks. The additional liquidity would then be used by the banks to extend new credit. However, banks may choose to hold the liquidity received in exchange for the bonds in their reserves at the central bank as a buffer. In this case, the liquidity provided by the central bank remains within the financial sector; it does not flow out of it. This risk can be minimised if the central bank conducts this type of operation only at the lower bound – that is, when it has fully exploited the standard interest rate channel. At the lower bound the remuneration of deposits is null (or almost null) and there is hence little or no incentive for banks to park excess reserves with the central bank. Deploying a policy of quantitative easing at a policy rate different from the lower bound may necessitate a larger expansion of the central bank’s balance sheet and thus increase the risk exposure of the monetary authority.

In light of the above considerations, the soundness of the financial system is critical to the success of quantitative easing. When banks stop intermediating loans, this policy no longer works. Quantitative easing is successful if it narrows the market spreads between the rates paid on selected credit instruments and policy rates, thereby limiting the risks of a liquidity shortfall and encouraging banks to extend credit to higher interest-paying parties.

The Bank of Japan’s policy between 2001 and 2006 provides one example of quantitative easing. It had the following key features: first, it involved a shift in the operational target for money market operations from the uncollateralised overnight call rate to the outstanding balance of current account deposits at the Bank of Japan, or in short the bank reserves; second, it entailed outright purchases of Japanese government bonds to meet the target balance of current account deposits at the Bank; and third, it involved an explicit, public commitment to maintain these open market operations until the CPI did not fall on a sustainable basis.

During that period, the Bank of Japan had discussions with academics about strategies for avoiding prolonged deflation. These talks repeatedly gave rise to one particular question: why didn’t the Bank of Japan simply allow the yen to depreciate in order to stop the fall in consumer prices? This is the essence of Lars Svensson’s prominent suggestion of ‘The Foolproof Way’ out of deflation.  But if it were so simple, why did the Japanese authorities apparently fail to take the necessary measures to prevent deflation? The answer is: it wasn’t that simple. What ‘The Foolproof Way’ underestimates is the enormous difficulty of turning around expectations of prices and economic activity when the functioning of the financial system is seriously impaired. The failures to restructure Japan’s financial and corporate sector and to recapitalise banks have been widely documented as key reasons for the country’s anaemic growth rates and declining prices  – factors over which the Bank of Japan had little control.

Let me just add something on that matter: ‘The Foolproof Way’ wouldn’t work in today’s context either. Given the global dimension of the current financial crisis, it would not be possible for all countries to depreciate their currencies at the same time in order to push inflation up. Such a beggar-thy-neighbour policy would be ineffective in the present circumstances; worse, it would aggravate them by unleashing a protectionist backlash. In fact, the leaders of the G20 recently agreed to refrain from competitive devaluation of their currencies, and it is important to stick to this objective in both words and deeds. Although not all countries belong to the G20, I am confident that all advanced economies will comply with this principle.

There are some important lessons we can learn from the experience of quantitative easing in Japan:

• To begin with, it cannot be taken for granted that an increase in the monetary base results in easier monetary conditions. In fact, the money multiplier has significantly decreased during the last decade. This has, to a certain extent, reduced the effect of injecting money into the economy. 
• Second, as mentioned before, the banking system is crucial for the success of a quantitative easing policy.  However, given the high degree of de-leveraging which the Japanese economy, and the banking sector in particular, was undergoing, banks did not find themselves in a position to pass on the additional liquidity to the non-financial sector.
• Third, one of the expected effects of quantitative easing is a flattening of the yield curve at longer maturity which improves the medium to longer-term financing conditions for the private sector. But what ultimately matters for investment and spending decisions is the real interest rate and hence inflation expectations. Strictly speaking, an increase in the money supply should have implications for the expectations of the future price level. But quantitative easing will only affect expected inflation if the increase in the size of the central bank’s balance sheet is not only sizeable but also perceived as being permanent.  The experience of the Bank of Japan provides a clear-cut example of a temporary expansion of the monetary base that did not affect private sector inflation expectations.
• Fourth, it is not clear how it is possible to increase inflation expectations in a significant way while avoiding a rise in the nominal long-term interest rate after some time. Setting the real long-term interest rate as the operational target for monetary policy seems to be rather challenging in an environment with developed financial markets.
• Fifth, if quantitative easing is perceived as being long-lasting then it could also have an expansionary effect by relaxing fiscal constraints. Expansionary fiscal policies represent a sound instrument to stimulate aggregate demand during a deflationary period. In this respect, outright purchases of government bonds by the monetary authority could further strengthen fiscal effects i) by accommodating the supply of governments bonds, ii) by affecting the long-end of the yield curve - the risk premium - and iii) by re-anchoring inflation expectations to a positive target. In particular, the transition to a positive inflation regime reduces the burden on the future fiscal budget by guaranteeing its financial sustainability.  Of course, the relevance of this effect crucially depends on the duration of the quantitative easing policy and on a credible commitment to a well-defined exit strategy. In this respect, the broad effects stemming from the fiscal and monetary policy mix have been quite muted in stimulating the Japanese economy.
• Finally, it should be recognised that a government bond purchasing programme involves the risk of accumulating significant losses for the central bank. Government bonds would be purchased at rather high prices. If the easing measure turned out to be a success, the ensuing economic recovery would gradually entail an increase in long-term interest rates; this would bring down government bond prices, so that the central bank would eventually face losses. Concerns about central bank’s balance sheet and financial independence can seriously impede monetary policy.  Such constraints may be one reason why the Bank of Japan’s government bond purchasing programme has failed to restore positive inflation rates.

Let me also mention that in the context of the euro area the design of such unconventional policy measures poses some intricate challenges, due to its unique institutional framework. In the first place, we need to be mindful of the Treaty requirements relating to the prohibition of monetary financing and the granting of privileged access, as well as of the consistency with the Treaty principle of open market economy and the preservation of the disciplining function of markets for borrowers and lenders.  Although purchases of government bonds are possible in the secondary market, there is a risk to eventually become a market maker for public debt, which could be construed to be against the Treaty prohibition of monetary financing. Moreover, we have more than just one fiscal authority in the euro area. The Eurosystem would have to decide how to spread purchases of government bonds across euro area countries. If, for example, the Eurosystem only concentrated on public bonds with the best credit rating, it would risk providing privileged access to some countries, contravening Article 102 of the Treaty. If it spread purchases according to a specific key and ended up affecting cross-country differences in yields, it would be seen as granting privileged access, as financing conditions for some governments would be supported to a greater extent than for others. It may also be the case that the risk-free component of corporate bonds would not move exactly in tandem with the risk-free component of government bond yields. This would be tantamount to giving preferential treatment to government debt. These issues would need to be addressed before implementing a government bond purchasing programme in the euro area.