In March, the Bank of England’s Monetary Policy Committee restarted the programme of asset purchases known as quantitative easing or QE to provide support for the economy during the coronavirus crisis. How does it work and does it constitute ‘monetary financing’?
At an unscheduled meeting on 19 March 2020, the Bank of England’s Monetary Policy Committee (MPC) decided to restart its asset purchase programme by purchasing £200 billion of UK government and corporate bonds in addition to the existing holdings of £445 billion. Such large-scale purchases by central banks – formally known as ‘quantitative easing’ (QE) policies in many countries – are made using newly created (digital) money.
What exactly is QE and why it is used by central banks? One key point to note is that is to does not constitute ‘monetary financing’, which, as explained here, economists are generally in favour of ruling out.
Monetary policy in practice
In most developed countries for the last 25 years, there has been a division of responsibilities in macroeconomic policy. Politicians in government have controlled public spending and taxation decisions (fiscal policy); while central banks have had independent control of interest rates (monetary policy) with the objective of keeping inflation under control.
Independence allows monetary policy-makers to make whatever choices are necessary to achieve their target, even where, for example, these decisions increase the costs of government borrowing. It also allows the central bank to stick to a medium-term objective, above and beyond the electoral cycle.
The central bank is prevented from directly financing the government’s deficit. Ruling out monetary financing means that governments have had to think carefully about how to fund their spending plans.
In practice in the UK, independence has meant that the MPC meets regularly to determine appropriate monetary policy. Until 2009, the MPC made decisions on the official interest rate. This rate – a short-term interest rate on lending to financial market participants – influences other interest rates in the economy, which in turn influence consumption, saving and investment decisions. Ultimately, these choices affect price-setting by firms (inflation).
In March 2009, however, the MPC also began to use QE as a policy tool.
Why did central banks stop using the interest rate to try to achieve its inflation target?
As a response to the 2008/09 global financial crisis, the Bank of England initially relied on lowering its key interest rate to stimulate the UK economy. But the extent of the economic slowdown in 2008 and 2009, and especially heightened financial risk and a general collapse of confidence in certain markets, required the Bank of England to exhaust its conventional stimulus options. Interest rates hit their so-called ‘lower bound’, which is around zero.
Having nominal rates bounded at (or near) zero reduced the scope for further reductions in interest rates. This is because although negative nominal interest rates may be possible, eventually holding money in cash (earning 0% interest) is better than depositing it for a negative return. Therefore, this constraint limited the Bank of England’s ability to affect economic conditions and so control inflation. To address this, and still with the aim of controlling inflation, the Bank began a programme of QE.
What is QE?
QE is a large-scale programme of asset purchases (Joyce et al, 2012). Specifically, the Bank of England purchases debt contracts (bonds), mainly of government debt (‘gilts’), from the existing owners of those debt contracts (the lenders to the government) in order to ease financial disruption and lower the cost of borrowing. In particular, it allows the central bank to influence directly interest rates of longer maturity. A lower cost of borrowing would boost consumption and investment, boosting demand and helping the Bank to achieve its inflation target.
Conventional interest rate control can also involve the central bank making purchases or sales in financial markets. Historically, these ‘open market operations’ were the norm to affect the short-term interest rate, but modern market operations have significantly reduced the need for such transactions.
These are often used when lending to a particular bank, which typically involves a temporary position in short-term bonds (such as one-month bonds). The temporary position is implemented via repurchase agreements (‘repos’), which commits the buyer and seller of the bond to reverse the position at agreed prices at a future date.
Current systems for implementing interest rate decisions require less adjustment of the quantity of reserves and hence less open market operations. But even relative to the old approach of implementing interest rate policy, QE typically has three distinctive features:
- The central bank’s QE purchases concentrate on the longer-maturity assets (such as 10-year bonds). In this sense, QE’s main goal is to reduce the long-term rates.
- The central bank purchases the assets outright and so doesn’t have a commitment to reverse the position at a particular date.
- It involves a wider array of assets including privately issued corporate bond securities.
As well as the boost (stimulus) to the economy at a time when short-term interest rates are constrained from falling further, by committing to purchase government securities, the central bank can support markets’ ability to function properly.
Is QE ‘monetary financing’?
Monetary financing is the direct transfer of money for the government to spend; of course, this could be via the direct purchasing of debt by the central bank. An advantage of monetary independence is to eliminate direct monetary financing. Because QE meant that the central bank expanded its balance sheets through the purchases of government debt, it blurred the separation of responsibilities between the fiscal authority and the monetary authority.
But although the demarcation between monetary and fiscal policy becomes blurred, QE does not constitute direct monetary financing. Similar to open market operations, the purchases are made in the secondary market, which means that, at least directly, the government does not receive any additional proceeds from the transactions.
Also, QE purchases can be sold back to the market (or allowed to mature and so run off the central bank balance sheet) if the central bank determines it is desirable. As such, QE is not permanent.
Monetary financing, on the other hand, would involve the creation of central bank money (mainly) to finance government deficits in a permanent fashion. (If the QE asset purchases are unlikely to be wound down, some would consider QE as an implicit form of monetary financing.)
The concern with monetary financing is that the creation of permanent central bank money happens at the cost of inflation. In the case of QE, however, given the stated time-limited nature of the purchases, the inflationary pressure is low.
Did QE work?
QE asset purchases are normally expected to affect markets via three channels:
- The signalling channel: asset purchases may convince markets that the central bank is committed to keeping interest rates low for a long time, which lowers the cost of borrowing for longer-maturity loans helping to boost demand. The central bank may explicitly announce this intention to keep interest rates low (forward guidance), but such announcements alone may not be credible. In this sense, QE and forward guidance reinforce one another.
- The scarcity channel: asset purchases reduce the supply of the purchased assets in the market. This pushes up the price of the asset and reduces the implied cost of borrowing for the issuer (the yield). The economic effects of this channel rely on ‘portfolio rebalancing’ by investors. Low interest rates can make riskier assets more attractive, as investors will search for higher returns. Some investors switch from buying the now-scarce government bonds to other bonds, which lowers the cost of other types of borrowing.
- The duration channel: by varying the relative supplies of specific assets with different maturities and liquidity, the central bank can decrease the yield on several long-term nominal assets – besides Treasury bonds – due the substitutability of these assets to some degree.
Existing empirical evidence is generally supportive of the effectiveness of QE (Fawley and Neely, 2013):
- Most evidence suggests that QE asset purchases have the intended type of effects on asset prices, particularly government bond yields.
- Research for the UK finds that the Bank of England’s QE program had effects on interest rates quantitatively similar to those reported for the United States. The evidence for the euro area is more mixed.
- Quantifying the wider macroeconomic effects of these policies is challenging given the obvious lags and uncertainty in the transmission mechanism and implementation of QE. Any such analysis relies on reliable counterfactual forecasts – what would have happened to the economy if QE had not been implemented. This is difficult because QE is implemented when the economy has entered a particularly precarious situation. Also, there were, at the time of its widespread adoption around the financial crisis, few historical precedents; Japan was the first country to make use of quantitative easing in the 1990s.
- Estimates based on the US, UK and Japanese experiences suggest that the signalling channel seems, on average, to have had the largest macroeconomic effects on GDP growth, compared with other channels.
What are the problems with QE?
One concern is that QE programs remove market discipline. As the central bank becomes a larger part of demand in the market, asset prices only partly reflect the valuations of private sector investors. Having said that, a distinction between changes in the UK’s Bank Rate and the policies of bond or asset purchases at the zero lower bound cannot be easily be drawn: both policies aim to alleviate tensions hampering the normal functioning of money and financial markets.
If QE is not coupled with adequate regulatory response, QE may lead to unsustainable private debt and/or asset price booms. Interest rates that remain low for long may boost asset and collateral values, leading both borrowers (households and firms) and banks to accept higher risks. As observed around the financial crisis, such developments can be extremely costly when they unwind.
Critics of QE programmes often contend that injecting liquidity into the economy may result in unwanted inflationary pressure. The possibility of inflation will depend on the state of the economy. In a recession, both households’ and firms’ demand for funding and banks’ credit may freeze because of risk or uncertainty. In this sense, QE may not always translate into greater liquidity (and hence inflation) to the real economy: banks may not increase lending to firms or households. This has necessitated the introduction of targeted lending and credit easing programmes on top of QE in many countries, including the UK.
Will additional rounds of QE work? What are the options for further stimulus?
More than ten years on since the introduction of QE in the UK, there are questions about its continuing effectiveness when central banks’ role as asset purchaser of last resort has become the norm. This leads to the question of how much central banks should expand their purchases and at what level of risk? There are no definitive answers to these questions.
The table below outlines the main policies choices that have been pursued by some of the world’s major central banks:
This leaves the UK with a number of options for further monetary stimulus (Chadha, 2020):
- There is some limited room for further stimulating the economy through additional QE purchases, despite long-term yields are already very low. In particular, purchases of corporate debt have remained a smaller component of QE in the UK than elsewhere.
- QE purchases of other riskier assets, such as equities, could provide an additional channel of stimulus, as done in Japan (see Table).
- There seems to be little additional monetary policy space left in terms of forward guidance. One suggested policy would be a strong commitment to change the central bank’s stated target, for example, increasing the inflation goal to above 2%.
- Despite the lower bound on interest rates, negative interest rates have been implemented by central banks in some countries. The emerging evidence for the euro area is encouraging, suggesting that negative rates have helped lending and financing conditions to a certain degree. There are, however, concerns that negative rates that are sustained for a long time could be counterproductive.
Where can I find out more?
Monetary policy in troubled times: Jagjit Chadha argues that the framework for monetary policy needs a close examination after the experiences of the global financial crisis and nearly 23 years of operational independence of the Bank of England, writing in the National Institute Economic Review.
Unconventional monetary policies – recent experience and prospects: Report by the International Monetary Fund.