Quantitative Easing: Its Mechanism, Aftermath, and Evaluation
While conventional monetary policies involve mild modifications of various metrics, unconventional policies are aggressive endeavors for a short-term major impact. Quantitative Easing (QE) is a major component of it, envisioned more than a decade ago for strong stimulation of a distressed economy. QE refers to large-scale purchases of securities, through which central banks directly pump a tremendous amount of cash into the market. For example, the Fed had already reduced the federal funds rate to zero in 2008 amid economic deterioration. While some European countries pushed down the rate to its negative, the Fed announced a plan of buying mortgage-backed securities and debt issued by government-sponsored enterprises. This was the beginning of the five-year long expansion period for the Fed’s balance sheet as well as the debate over QE and its application. (1) (2) (3)
Based on the rule of supply and demand, QE, by design, works in a straightforward fashion. After the large-scale purchases, the cash payments from the Fed increase the money supply in the market, which is expected to exert downward pressure on the interest rate. At a lower interest rate, the borrowing cost for households and firms is reduced, which encourages credit and boosts aggregate demand. Theoretically, this cycle will repeat itself, inducing a long-term rise of both inflation and total output. But reality is more complicated than theories and QE may have more complex consequences than originally intended.
The theory may falsely predict how money enters the economy. The confusion lies in the misconception of equalizing the deposits of a central-bank to the ordinary money which is used actively in the economy. While the former becomes reserves of the banking system, the latter is the credit on a commercial bank. QE is not the Fed printing more physical dollar bills than usual. As such, the injected money will not go directly into the hands of ordinary investors, consumers, producers, and other non-bank fundamental aspects of society. When the Fed buys holdings from ordinary investors, it credits the seller’s bank with more reserves and the bank credits the investor with more ordinary money shown on a bigger account balance. More money is available to the market as the investor is encouraged to invest more. The money multiplier effect takes place at the same time from the bank’s perspective —more money is created as the bank is encouraged to loan out more. Still, the extent of the impact and the actual conversion rate remains an uncertainty. In another situation, if the Fed buys the holdings from banks, there will be no money creation. The same is true in a situation in which the proceeds are used to pay down existing debt. These specifications matter, as the Bank of England estimated that about 40% of the effect of its QE was offset. The rest of the cash, after taking account of the leakage, contributes to an effect called “Portfolio Rebalancing.” As the yields decline, investors are pushed to riskier asset classes. Thus, money flow depends more on the prices than quantity. (2)
Quantitative easing also endangers financial stability. QE directly increases pressure on banks’ profitability. As large-scale purchases of long-term treasury bonds reduces its supply and pushes up its price, long-term yield will be trimmed. Term premium, the difference between short-term and long-term treasury yield, will be compressed. The same is true for banks’ profit margins. Portfolio Rebalancing, as mentioned above, also impairs financial stability. Aside from aggressive investors, others, who are supposed to implement conservative approaches, are forced to shift strategies as well. For example, pension funds and insurance companies, as long-term asset holders, fail to meet promised yields on their long-term liabilities with relatively safe assets—long-term treasury securities. Therefore, they have to incorporate riskier assets despite the fact that increased risk to these managers can be very dangerous. Any impairment of their repaying capacity will have a considerable ripple effect, directly damaging the benefit to the general public. Furthermore, large-scale purchase of assets deviates price from its fundamental volatility which may need a sharp asset-price correction in the future that may incur potential liquidity risk. There is also the concern that the central banks’ hard-fought independence may be jeopardized by implementing quantitative easing. Political pressure is expected with the usage of such policy. (3)
Evidence on how unconventional monetary policy affects beyond interest rate is limited. With that being said, existing studies suggest positive impacts of unconventional monetary policy on both GDP and inflation. Another approach to the effectiveness of QE in U.S. markets is provided by the analysis of Kenneth N. Kuttner, which suggests that QE is likely to be more effective in three scenarios. These scenarios have real-life examples that show very different results of unconventional monetary policy. First, the easing has the strongest effect on the recession in its most distressing periods. Second, unconventional monetary policy is less effective when deflationary pressures are entrenched, so that quantitative easing can only have a limited impact on further reducing yields. Third, unconventional monetary policies require central banks’ credibility in its commitment to providing sustained monetary accommodation. Given the scenario analysis above, the U.S. unconventional monetary policy is arguably successful for its large scale at the most critical moment, its continuous moderate inflation during the pre-recession period, and the long-term commitment of the Fed. (3)
Despite its benefits, unconventional monetary can be improved from six potential aspects. First, it should be conducted in a strictly disciplined manner, with pre-arranged planning and precise execution. Second, it should focus on expanding the Fed’s balance sheet. Third, forward guidance and quantitative easing should be operated as complements. Fourth, central banks should be more concerned about their wavering independence, reserving it for the truly emergent situations. Fifth, the selection of assets for purchase can be more refined. Mixing and matching a wider variety of assets with different risk level, exposures, and duration may reduce the volatility incurred by the policy while retaining its effectiveness. Sixth, unconventional and conventional monetary policies can be conducted concurrently by central banks. (3)
Chappelow, Jim. “Quantitative Easing Definition.” Investopedia, Investopedia, 4 June 2019, https://www.investopedia.com/terms/q/quantitative-easing.asp.
Kuttner, Kenneth N. “Outside the Box: Unconventional Monetary Policy in the Great Recession and Beyond.” Journal of Economic Perspectives, vol. 32, no. 4, 2018, pp. 121–146., doi:10.1257/jep.32.4.121.
Mackintosh, James. “Don't Worry About the End of QE, Worry About Rates.” The Wall Street Journal, Dow Jones & Company, 6 Aug. 2018, https://www.wsj.com/articles/dont-worry-about-the-end-of-qe-worry-about-rates-1533580338.