This essay contains three parts. The first is to express the meaning of quantitative easing and the differences between traditional way and quantitative easing method. The second part is to explain the mechanism of quantitative easing and how does it to affect the economic activity. The five QE transmission channels are extracted from Bank of England, which is the most officially explanations and the main ideas have been paraphrased and using simple words to express as much as possible. In last part, talk about the implications of QE in different countries and attempt to discuss the limitations of QE and the broader monetary policy through finding out the ultimate source of global financial crisis. In conclusion, the central message to judge whether QE will succeed is that as the unconventional instrument of monetary policy, QE might be helpful to solve some urgently issues and to achieve the targeted inflation rate for central bank, however, the ultimate sources of current issues in global economy should be reviewed systematically and it is necessary to solve those problems through comprehensive policy instruments.
What is quantitative easing?
Quantitative easing is not a traditional way for central bank to intervene the economy. In order to define and express the quantitative easing accurately, it might be essential to capture the differences between traditional way and quantitative easing method. In usual case, central banks aim to increase the amount of lending activities in the economy indirectly through cutting interest rates, which is the fundamental policy instrument to maximize the employment (http://www.bbc.co.uk/news/business-15198789).
In practice, central banks employ open market operations to achieve the interest rate adjustment, which is the buying and selling of short term government bonds on the open market by a central bank. In detail, when central bank sells short term government bond to open market, which means the aggregate money supply would decrease. It is because that a part of money are no longer flowed in market as usual, instead, they are transformed to government bonds and hold by investors. In the opposite situation, when central bank buys short term government bond from open market, which means new money are injected to market by central bank through buying short term government bonds from investors.
In fact, the change of aggregate money supply is not the ultimate goal for central bank, instead, the short term market interest rate adjustment is the real policy intention for open market operations.
However, there is one particular scenario that open market operation mechanism cannot affect the interest rate, which is called liquidity trap. In normal cases, when there is new money flooded into market, the most probability reactions for rational individuals are to increase consumption/ investment and further boost the economic prosperity thanks to expansionary monetary policy. However, if people keep on hoarding cash no matter how new money flooded into market, it does not make sense that market interest rate would be adjusted due to money supply effects. In that case, the short term interest rate is either at or close to zero. At that time, the only option for central bank is to pump money into the economy directly, which is referred as quantitative easing. Under the quantitative easing method, the central bank would like to buy long term financial asset and thereby lowering long term interest rates. (http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm).
The mechanism of quantitative easing to economy
There are five QE transmission channels. They are confidence, policy signaling, portfolio rebalancing, market liquidity and money (Bank of England, quarterly bulletin, 2011).
Policy signaling effects
This channel contains anything that economic agents predict the future monetary policy through the understanding of current policy, such as asset purchases (Bank of England, quarterly bulletin, 2011) For instance, asset purchases might release a strong signal that monetary authority aim to meet the inflation target or keep the interest rate at a lower level in a relatively long period. In fact, policymakers were concerned about the risk of deflation, which could decrease aggregate demand, lower economic activity or even serious recessions. Asset purchases could help to support spending through the signaling, which indicates inflation expectation is consistent with target (Bank of England, quarterly bulletin, 2011). Bernanke (2003) also presented that there is a strong link between monetary policy and stock market performance, it is because the most peers in stock market are extremely sensitive to relevant policy information and good at analyzing sophisticatedly (http://www.federalreserve.gov/boarddocs/speeches/2003/20031002/default.htm).
Portfolio balance effects:
In this channel, central bank asset purchases would push up the prices of assets (Bank of England, quarterly bulletin, 2011). In practice, when central bank purchases financial assets from market, it would increase the money holdings of investors. With more money holdings, it would definitely increase the purchasing power of individuals. Since the preferences of investors are different, some of them might be risk averse, some others may like to bear high risk and expect high return. With the money holding, it is likely to purchase financial assets for most of investors, unless for some that regarding money as the same characteristics with financial asset. With more financial assets transactions, in aggregate, it would boost the financial market prosperity and increase the overall price of assets. In general case, higher asset prices mean lower yields and reduce the cost of borrowings for households and companies, which would boost the spending gradually (Bank of England, inflation report, 2009). In addition, the higher asset prices could stimulate spending due to increase the net wealth effect of asset holders (Bank of England, quarterly bulletin, 2011).
In this channel, asset purchases might have broader confidence effects thanks to higher asset prices (Bank of England, quarterly bulletin, 2011). In detail, once policy implemented to increase the economic outlook or overall market performance, it is most likely to enhance consumer confidence and boost the personal consumption or company investment.
Bank lending effect
“When assets are purchased from non-banks, the banking sector gains both new reserves at the Bank of England and a corresponding increase in customer deposits” With the more liquidity asset that banks have, it is possible to encourage bank increase the new loans. However, due to the size of balance sheet from bank’s own considerations and time lagged effects, the Monetary Policy Committee does not expect the substantial effects through this channel (Bank of England, quarterly bulletin, 2011).
Does quantitative easing really work under the current global economic circumstances?
When talk about the effectiveness of policy instruments, it is necessary to check the history experiences and also the market reactions or economic indicators after that policy employed. In the same principle, to discuss whether the quantitative easing will succeed, we need to know the relevant information that quantitative easing got used or being used in specific countries.
Implications in different countries
Japan is the first country that officially adopted quantitative easing, which started from new millennium and ended in 2006. Bank of England adopted the policy of the same name as Japan in March, 2009. At nearly the same time, the US central bank adopted a policy that called credit easing, with which the Fed chairman Bernanke aimed to differentiate from Japanese-style quantitative easing (Konstantinos Voutsinas, Richard A. Werner, 2010). However, as the report from Financial Times, the chair of Bank of Japan admitted that quantitative easing in Japan was ineffective (Financial times, December, 2009).
In terms of UK, the quantitative easing asset purchase program is £275 billion and the current bank rate is 0.5% (Bank of England, 2011). As BBC news report, the current interest rate is the lowest in the history of Bank of England. There are different opinions in terms of whether the policy has worked among analysts. But as one professional analyst commented, we never know the consequences of economy if without the quantitative easing program. (http://www.bbc.co.uk/news/business-15198789).
In other words, the key economic indicators could represent the aggregate performance of economy and also could be used to test whether the quantitative easing program has achieved its initial goals to some extent. In Britain, the background of quantitative easing is that Bank of England’s Monetary Policy Committee (MPC) judged that traditional ways to conduct expansionary monetary policy might fail to meet the 2% CPI inflation target in the medium term, and therefore decided to begin a programme of large scale purchases of private and public assets(Bank of England, quarterly Bulletin, 2011). In 2009, the overall inflation rate was about 2.16% (Office for National Statistics, 2011), which was slightly above the policy goal. It seems that Bank of England succeeded in achieving its goal through quantitative easing program. Similarly, in terms of unemployment rate, the figure also did not fluctuate too much since July 2009, most of monthly data were spread out around 8% (Office for National Statistics, 2011). Even though the job recovery is not good enough, but it might be reasonable to believe that if without quantitative easing program, the macro economy may be worse off and would lose more job positions.
In the U.S., under the credit easing program, the Fed buys government or other bonds and writes down that it has done so — what is called “expanding the balance sheet.” As a result, the Fed’s balance sheet boomed from about $ 900 billion to over $2 trillion as the program implemented. Initially, Fed aimed to end that program in the early of 2010, but the recovery did not goes properly so that Fed announced a new round that attempt to curb low inflation and high unemployment persistently. (http://topics.nytimes.com/top/reference/timestopics/subjects/q/quantitative_easing/index.html). It is hard to say whether Fed succeeded or will succeed to achieve their goals through quantitative easing in simple words.
Limitations for Quantitative easing and broader monetary policies
It is true for all central banks that maximize employment with the relatively lowest corresponded inflation rate are core goals. However, it might be also true that many policymakers or individuals put too weights on central bank and regarding monetary policy as nearly the sole instrument to stabilize economy or boost the prosperity in long run. It is necessary to recall that why central bank has to adopt quantitative easing. In Japan, the mainly problem that policymaker want to solve is the deflation problem. In most recently cases, both UK and US, the reason for implementing quantitative easing is that the extremely seriously aftermath of global financial crises. Why do not try to figure out the underlying factors of currently financial crisis or attempt to find out the new model of global governance framework?
It is known that progress of globalization has influenced the economic outlook dramatically and the current policy communities or regulations might fail to meet with the needs of new model economy. In developed countries, many job losses are not due on lack of purchasing power or spending demand, but thanks to the rush of cheap goods from developing countries. With the low skilled workers lose job opportunity in developed countries, the income inequality cannot be avoided if the education system or labor market is still rigidity enough. New York times(2010) revealed an interview with former chief economist of the International Monetary Fund, Professor Raghuram Ranjan, he asserted that income inequality is the ultimate source to cause the global financial crisis and the situation would be worse off if government fail to reform current education system in order to make more population well educated or high productivity or provide enough training program to help those disadvantage groups. In fact, to solve the deep problem, only rely on monetary policy is far less enough.
Policymakers should broad their visions on policy options and attempt to use combinations of policy instruments to solve economic problems.
Bank of England, Inflation report, 2009
Bank of England, Quarterly Bulletin, 2011
Bank of England, Key Facts, 2011
BBC News, Business, Quantitative Easing.
Financial times, December, 2009 BoJ offers banks cheap loans http://www.ft.com/intl/cms/s/0/f4221068-de52-11de-89c2-00144feab49a.html#axzz1fo3GOhCj
Federal Reserve, The Crisis and the Policy Response Speech by Chairman of Ben S. Bernanke, At the Stamp Lecture, London School of Economics, London, England, January 13, 2009 http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
The Federal Reserve Board, Remarks by Governor Ben S. Bernanke, Monetary Policy and the Stock Market: Some Empirical Results http://www.federalreserve.gov/boarddocs/speeches/2003/20031002/default.htm
Office for National Statistics, 2011
Konstantinos Voutsinas, Richard A. Werner, New Evidence on the Effectiveness of ‘Quantitative Easing’ and the Accountability of the Central Bank in
Japan. 6 June, 2010
The New York Times, Times Topic, Quantitative Easing
Freakonomics, Predicting the Financial Crisis: A Q&A with Fault Lines Author Raghuram Rajan http://www.freakonomics.com/2010/06/17/predicting-the-financial-crisis-a-qa-with-fault-lines-author-raghuram-rajan/