Quantitative Easing as a Policy - Research Paper Example

? [Quantitative Easing as a policy] Introduction Quantitative easing (QE) is the unconventional monetary policy that central banks apply to stimulate the economy after the ineffective of other conventional monetary policies. Quantitative easing is implemented through the buying of financial assets from private institutions and commercial banks. This will inject predetermined money back into the economy hence increasing the excess reserves in the banks while raising the prices of the bought assets. For the purpose of this paper, qualitative easing will be defined as the large scale purchasing of financial assets in exchange of central bank reserves. Following the 2008, financial crisis qualitative easing became an element of recovery to the central banks that their interest rates were close to zero lower bound or at zero (Benford, Berry, Nikolov, & Young, 2009). With the intensification of the crisis, most international central banks took possible measures in supporting demand and loosening monetary policies. The bank of England through its monetary policy committee (MPC) dealt with it by cutting interest rates by up to three percentage points in bank rate. In early 2009, the bank further reduced it by one and half percent. MPC in their analysis explained that the cut could not meet the consumer price index of two percent hence need to purchase private and public assets using the central bank money. This led to the introduction of qualitative easing in the United Kingdom economy. The idea behind this was to inject liquid money back into the economy to help boost nominal spending and achieve the two percent inflation target. Discussion To avert the financial crisis, the bank of England purchased a large amount of United Kingdom governments bonds (gilts). By January 2010, the bank had purchased medium and long-dated gilts worth 200 billion of assets, and this represented fourteen percent of annual GDP and 30 percent of private sector outstanding gilts. In so doing, and by a combination of support measures the bank balance sheet increased in relation to the GDP threefold before the crisis. To implement this technique further, the government gave authority to the bank to purchase corporate bonds and high quality paper. The government did so in order to improve market functioning by acting as a backstop buyer and seller (Hamilton, 2010). The asset purchasing is one of the unconventional policy measures applied in the bank to loosen the monetary policy. The bank aim of assets purchasing was to cut the bank rates and hence stimulating nominal spending with the aim of meeting the two percent inflation target. This initiative also alleviated inflation that had been domestically generated. Assets purchases affected inflation and spending through different potential channels. First, it increased money holdings and pushed up the assets prices while stimulating the expenditure by increasing wealth and lowering borrowing costs. It also stimulated impact by broadening expectations and its influence on bank lending rates. Effects of assets purchasing The purchasing of assets led to Policy signaling effects, which included the expectations by market participants of policy rates to remain low for longer. At the time of expectations, policy makers were dealing with the issue of falling inflation below the expected medium target. The falling of inflation could have led to push up on real interest rates while reducing spending and keeping of nominal rates at low levels (Hancock, & Passmore, 2011). The assets purchase assisted in keeping inflation expectations on target through supporting of spending. The signaling effect anchored inflation expectations on track hence the hiding the real state of the economy to the agents on their views. The other effect of assets purchasing in stabilizing the economy was through portfolio balance effects, which entailed pushing up prices of other assets and the bought assets. This happened in the sense that after the bank buying assets, there is an increase in money holdings by the sellers. Money was a perfect substitute of the assets sold, the sellers rebalanced their portfolios through buying of other better assets. The continuous exchange of assets in quest of rebalancing of portfolios by sellers and buyers led to raising of assets prices. The higher assets prices lower borrowing costs and yields hence stimulation of spending leading to aggregate willingness by investors to hold supplies of money and assets (Doh, 2010). The assets purchasing through portfolio effect stimulate spending thus increase in wealth of assets holders. Portfolio balance effects reduces the spreading of long-term rates in the expected policy rates while policy signaling effect work by affecting the expected policy rates. This portfolio effect led to liquidity Premia effects. The liquidity effect functioned when the central bank increases liquidity through assets purchasing hence encouraging trading. Assets prices increased when the Premia for illiquidity was lowered. Other channels in which assets purchasing assisted the economy are the impact of confidence effects, which arose due to effects of higher asset prices. The policy led to improve in the economic outlook thus boosting customer confidence and the willingness to buy. There were also bank lending rates effects, which led to increases in customer deposits encouraging bank to continue lending loans, which might not have been the case. Adjustment by the economy To analyze how economy adjusted to qualitative easing we break the overall effects into two stages. The first stage is the impact phase, which shows how assets purchases changed the private sector portfolio leading to decrease in the long term and medium gilts (Joyce & Meldrum, 2008). Qualitative easing also led to increase in broad money holdings, but because money and gilts are not perfect substitutes thus creating the initial imbalance. With the portfolios rebalancing assets, prices went up restoring the equilibrium in assets and money markets. The signaling effect and other effects leading to increase in assets prices reinforced this effect. The impact phase was also characterized by demand increase caused by lower borrowing rates and higher wealth making the consumer prices go up. In the adjustment phase, there was an increase in supply of long-term assets and money balances caused by rising assets and consumer prices. This led to the shrinking in the initial money imbalance and markets assets hence the beginning of real assets falls back. It also led to demand boost, which in turn caused the price level t increases by smaller units (Inkinen, Stringa, & Voutsinou, 2010). During the adjustment phase, the process was continuous until when the price level had risen to sufficient levels of restoring the real output and money balances. From this position, the qualitative easing trough deficient demand was able to accelerate the return of equilibrium in the economy. The implications of Quantitative Easing The first implication was to the savers, the changes in the bank rates and the pushing up of assets price range led to boosted value for wealth hence increase in savings interest. QE pushed down gilt yields and reducing the annuity rate pensioners were experienced neutral impact on their annuity income hence rise in an increase in prices of bonds held in pension pots. From QE, the flows of equities in the pension pots become higher leading to increased in divided interest. Without QE, savers might have lost their jobs due to collapse of business and due to the impact of inflation. Considering other things constant the consumption and the buying power of savers could have reduced owing to inflation rates. The high inflation led to consequences that were distributional. The common household felt the impact of loose monetary policy through the low nominal interest rates paid on loans and stock deposits. This reduced the interest that the savers received on savings and those paid by debtors. The downward pressures on longer-term rates caused by QE played a pivotal role in the determination of the impact as compared to lowering of rates by banks. This type of policy affected individuals depending on their method of savings, increases in the value and amount of equities. Design and operations The Bank of England has attached importance to portfolio balance channel in implementing the assets purchases program. This led to targeting of purchases in the long term assets that were being held by pensions funds and insurers the two being non banking financial institutions. Portfolio channel encouraged the financial institutions to invest the funds in assets purchase programs rather than the risky assets of equities and bonds (Eggertsson, & Woodford 2003). Another implication is cited at the end of the year 2008. United Kingdom banks used to hold four percent of the total stock of gilts, but after the introduction of the scheme, the banking sector increased their holdings. In this period, also the bank was conducting assets purchases with the aim of reducing the gilt that non-bank private sector were holding. Assets purchases proved that the bank could continue with its agenda of loosen monetary policy while stimulating demand even with low bank rate. The expectation could have led to change in macroeconomic future distribution thus reduction in risk Premia with an increase in consumer confidence. In such a situation, liquidity Premia was necessary in designing bank purchases in respect to private sector assets. It was through this program that there was improving in the availability of market finance accompanied with improve in liquidity in other sectors of the economy. In this method, purchases increased the confidence of the issuers and investors because they could find buyers for the bought assets in case of urgent sell. Operational considerations The Chancellor of Exchequer and the Governor of the Bank of England made the Asset Purchase Facility of Bank of England official on January 2009 with the authority. After its approval APF become a tool for monetary policy implementation in purchasing assets created by the central bank money. The MPC purpose in the scheme was to review program with the aim of conducting policies in terms of targets. They did it with caution of not generating additional disorder in the market through conducting of purchases in paces of not longer than one month. They implemented this by buying ? 75 billion of assets in the first three months conducted in a monthly rate of ? 25 billion. After the end of the three months, they reduced it to ?16 and later ?8 billion a month. By the end of the period, they had purchased assets totaling ?200 gilts included. The Bank of England with concern of not disrupting the gilt market executed MPC decision. To alleviate the likelihood of gilt market becoming dislocated the bank started lending proportion that had bought and buying readily available gilts. In the same period, the bank extended maturity of the purchase gilt from five to 25 years because most gilts held by bank matured after five years. Conventional yields formed the bulk of the Bank of England’s asset purchases and hence it was expected to yield the biggest impact on the gilt market. After the announcement of gilt sell, the reaction towards other assets prices was unequivocal as compared to those of gilt prices. Corporate bond yields had a clear reaction while the corporate yields fell by over 70 basis after the first six quantitative easing announcements. In the same period and after the announcement international investment grade bonds yields experienced a fall suggesting the presence of effects specific to United Kingdom. The reaction of equity prices was not uniform in response to news of QE. All share index of FTSE fell slightly after February inflation report and later fell sharply following the MPC announcement of March. The QE led to the firms responding to higher corporate bond prices and equity hence increases in the use of capital markets in raising funds. Inflation expectations were expected to increase after the implementation of qualitative easing and due to response to monetary stimulus. In this analysis, QE had helped in reducing the weights on persisting inflation with accompaniment from import and energy prices. It was also evident that the banking sector was disinter mediated by United kingdom firms through the motive of issuance of higher capital and market equity relative to bank borrowing. To the extent, also the QE also was characterized by facilitating the rebuilding of bank balance sheet while ensuring less growth rate in lending rates. Quantitative easing managed to achieve this through ensuring lower borrowing rates, however, there is no evidence that it made the household or firms bank lending rates effective. In terms of confidence, it was also hard to differentiate the impact of other factors and that of QE in alleviating the economy crisis. Conclusion In conclusion, the speed, and the scale of this of this program was with the intention of reversing confidence that had decline due to the risks of inflation that were below the target in respect to medium terms(Cross, Fisher, & Weeken, 2010). However, in the end it was redesign to target the purchase of long dated and medium gilts from the private and non-bank financial sectors. In the course of this program, gilt yields underwent depression up to hundred basis points while the only evident impact was from assets prices. The broader effects of this scheme are in relation to range of assets that can be discerned, but wit difficulties due to the incurred influences and lags involved. The general expectation of quantitative easing is the conventional effects on inflation after affecting output. Finally, in alleviating the economic crisis in United Kingdom the MPC may in the future decide to begin the process of selling back the assets or increasing assets purchases. 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