Quantitative Easing and Bonds - Case Study Example

QUANTITATIVE EASING By Location Quantitative Easing Introduction Quantitative easing (QE) refers to an unconventional monetary policy that enables the central banks to perform a stimulating on the economy when the standard monetary policy has been discovered to be ineffective. Central banks achieve the implementation of quantitative easing by purchasing certain quantities of financial assets from commercial and other privately owned institutions. The typical outcome of such transactions is the increase in the monetary base. Such a transaction can also lead to lowering of the yield for the financial assets that have been purchased by the central bank. Quantitative easing can also be used in situations where the use of expansionary monetary policy has failed to work. Central banks use expansionary monetary policy to stimulate the economy by purchasing short-term government bonds with the aim of lowering short-term interest rates. When it fails, quantitative asing can be used to further stimulate the economy by buying assets with longer maturity as compared to the short-term government bonds. This paper aims at discussing the effectiveness of central banks using Quantitative Easing to buy assets with longer maturity as compared to the short-term government bonds in order to stimulate the economy. Theoretical Analysis The Bank of Japan (BOJ) was the first central bank globally to use quantitative easing. This happened in the year 2000, and in this instance it was mainly used to reduce domestic deflation. In the year 2001, the Bank of Japan claimed quantitative easing could not be effective and thus recommended it is the rejection of its use for monetary policy. Without using quantitative easing, the Bank of Japan had been able to maintain short-term interest close to zero by the year 1999. However, with quantitative easing, commercial banks were flooded with excess liquidity that promotes private lending (Davies & Green 2010, p. 99). As a result of this lending, commercial banks were left with large stock of excess reserves. This therefore led to less risk of there being a liquidity shortage. This was attained through the Bank of Japan buying more government bonds than it would actually be needed to set the interest rates to zero. Quantitative easing eventually brought securities and equities that are asset backed. Quantitative easing also ensured that the Bank of Japan’s commercial paper operation terms was extended. These activities of the Bank of Japan saw an increase of the commercial; current account balance to ¥35 trillion from ¥5 trillion in a period of just four years beginning from the year 2001. The Bank of Japan also increased the amount of long-term Japanese government bonds that they could buy on a monthly to a quantity that was three times the previous quantity. Quantitative easing has also been used in the United States of America to buy long-term government with the aims of stimulating the economy. In the year 2010, the Fed decided to use quantitative easing to jump start the US economy, which at that moment seemed to be going through a sluggish recovery process. This process was characterized by spending hundreds of billions US Dollars to buy US treasury. The main aim of doing this was introducing an inflationary pressure on the economy of the United States of America. In the United States of America the use of quantitative easing in this manner came to be popularly known as the QE2. This is because this was the second time the Fed was making use of quantitative easing to stimulate the economy of the United States of America (Hormann & Schabert 2011, p. 135). Quantitative easing has also been used as a tool for economic stimulation in the United Kingdom. In the year 2010 the Monetary Policy Committee (MPC) decided to increase to increase the central bank’s total asset purchase to the value of £200 billion. A very huge percentage of the financial assets that were bought with this money were the United Kingdom government securities. Since then there has been a gradual increase in the amount of money that is allocated to the purchase of government securities. The bank also refused to purchase more than 70% of any government debt issue. This meant that another institution and not the Bank of England held more than 30% of the government of United Kingdoms’ issues of debt. This was particularly found to have benefited the asset holder in various ways (Klyuev, De Imus & Srinivasan 2009, p. 131). Richer holders ended up benefiting most of the quantitative easing process. evidently, these factors place a salient compulsion on the central banks to develop strategies of regulating other financial institutions. Quantitative easing has also been used in various instances in the European Union. In the year 2010, the European Central Bank invested about €60 billion of their finances on purchasing covered bonds. This form of investment is commonly known to be a form of corporate debt. This was an increase given that fact that in the previous year they had spent less financial resources on such bonds. In the year 2013, the Swiss National Bank recorded the highest largest balance sheet in relation to the economy that this bank held responsibility. This was initially done to further stimulate the economy by buying assets with longer maturity as compared to the short-term government bonds (Boyes & Melvin 2013, p. 92). This seemed to be working during the initial stages. This was close to 100% of the national output of Switzerland. Almost 12% of the revenues of the Swiss National Bank were foreign equities. Empirical Analysis In japan, the central bank had to come up with a way to amend for the damages that had been caused by tsunami, earthquakes, and nuclear meltdown. In response to this, the central bank saw that by undertaking quantitative easing in large scale, they will be able to rescue the economy that was becoming worse as the days went by. This was done with the aim of changing the worrying trend of low inflation in Japan (Fasano-Filho, Fasano-Filho & Wang 2002, p. 111). A relatively small quantitative easing program was carried out in October 2010. This program led to a more aggressive quantitative easing program in April 2013. The result of these quantitative easing programs on inflation was noticed to be minimal, almost negligible. Despite having been able, to raise the monetary base, economists now argue that monetary base might not have that much influence of inflation. The economic problem that such programs were aimed at solving is the recurrent problem of having low market prices with very low economic growth. Quantitative easing, thus aimed at stimulating the Japan economy by long-term government bonds, thus allowing a rise in the bond prices, lowers their yields and availing a helpful boost to growth (Callen & Ostry 2003, p. 201). This is a classic demonstration of the efficiency of quantitative easing as a reliable strategy to trigger financial growth. The success of the case studies explored in this paper only serve to recommend the efficiency of quantitative easing. In the United States of America, quantitative easing was used to cause an inflationary effect on the economy of the United States of America. This is because during QE2 was estimated to have caused a fall in the Fed fund rates to 0-0.25 from the previous rate of 3%. It was estimated that in the year 2010, the Fed spent over $600 billion to buy treasury bonds. They did this to respond to the economy’s weakness that was a result of lower consumer spending and minimal growth of the GDP. They also acted because of the fear of performance of the Japanese economy in the 1990s. At this moment, this was the only options because all the standard monetary policies had been unsuccessful in preventing prolonged deflation. So the Fed saw this as the only method through which they could discourage the buying of secure bond by making them expensive, so there would be the option of either buying them at that cost or opting for other types of bonds (Klyuev, De Imus & Srinivasan 2009, 151). The Bank of England had bought about £165 billion in assets by September 2009 and about £175 billion in assets by the end of the month October 2010. At the Bank of England meeting in November 2010, the Monetary Policy Committee (MPC) decided to increase total asset purchases. Most of the assets purchased by the Bank of England were UK government securities, mostly gilts. The Bank of England has also bought smaller amounts of private sector assets, especially those of high quality. In the year 2010, in the month of December a member of MPC by the name Adam Posen proposed for a £50 billion increment of the Bank of England’s quantitative easing programme expenditure, while one of his colleagues Andrew Sentance also proposed for an increase in interest rates because of inflation being above the rate they had targeted of 2%. The Bank of England revealed that it would carry out another round of QE In October 2011. This round of QE was expected to create an additional expenditure of £75 billion. In the month of February 2012 Monetary Policy Committee (MPC) revealed that there would be an additional £50 billion. In July 2012 MPC revealed yet another £50 billion, making the total amount spent £375 billion. In Europe, quantitative easing had also been used in various occasions. The European Central Bank focused on purchasing covered bonds. This was a form of corporate debt. The European Central Bank had initial purchases of worth about €60 billion in 2009.At the beginning of the year 2013 the Swiss National Bank had the largest balance sheet in comparison to the size of the economy it was responding to. 12% of European Central Bank’s reserves were in foreign equities. The Federal Reserves holdings were equal to about 20% of GDP of the United States of America, while the its assets were estimated to be worth about 30% of GDP (Blinder, 2010, p. 108). Discussion Before the introduction of quantitative easing long-term interest rates fall would much more. This means the subsequent economic recovery would not take that long. However, as when the economy picks up, there is a rise in long-term rates, because participants in the local bond market have feared the central bank can have to unload its holdings of long-term bonds in order to mop up all the excess reserves. As a result, there is always a fall in demand in the sectors that have sensitivity in interest rates. This forces the economy slow down leading to a situation where the central banks have to relax their policy stance. This triggers the beginning of the economy again (Rochon 2011, p. 123). However, participants in the market remain in fear of excess reserves being absorbed by the central bank. A different trend was discovered in economies where quantitative easing. The decline in the long-term rates was discovered to be more gradual thus making the recovery process slower. However, because the central bank does not have to accumulate large amounts of funds, people are not relaxed when the recovery commences (Skene 2009, p. 109). The rise of long-term rates was also discovered to be more gradual in this case. Immediately the economy begins to turn around, the recovery becomes faster because of the lower rates. Conclusion Critical analysis of quantitative easing and its effects have proved that it only benefits the rich and not the middle class citizens of a country. This is because it can affect the GPD only by making those in possession of assets feel that they are richer thus encouraging them to spend more. Therefore, quantitative easing can be said to be one of the primary causes of the big gap between the wealthy class and the middle class The provision of financial assistance to banks can be a counterproductive endeavour. This is because it can result in an increase losses incurred by banks. This would be an indicative compromise of forbearance. Hence, this factor that motivates the financial institutions to consider risks that present futile prospects at the expense of the government. Forbearance presents critical consequences, with one being the compromise minimizing the net worth value, and this can thus cause crippling tax load to finance bailouts for banks (Taylor & Weerapana, 2012, p. 117). Another outcome might be a serious contraction in the expected supply of credit, prompting a decline in the economy that would not have been experienced forbearance was not there. There are analyses that serve to highlight the existing policies namely explicit government assurance on liabilities of financial institutions’, substantial liquidity support, and the demonstration of forbearance in cases where certain stringent regulations prove useful. This is the case because some of these policies do not automatically lead to an increase in the pace in which the economy recovers. This will only mean that these methods are not after all, completely effective in economic stimulation. Central banks often exhibit preference for a demonstrated level of stability specifically in the period when containment is mandatory. During such times, the bank may face the compulsion to exhibit a liberal consideration, offering banks categorized as of illiquid potential, and the consequences present no solvent prospects. The blanket government guarantees can bear the cost of putting a hidden load on the national budget, but only if the government’s political and fiscal position makes them credible. All these factors prove that the quantitative easing through purchasing of government bond can only be effective as a short-term solution for the economy. Therefore, they cannot be effective as a long-term solution for the economic problems. Bibliography Bakker, A. F. P., & Herpt, I. R. Y. V 2007. Central bank reserve management: new trends, from liquidity to return, E. Elgar, Cheltenham. Blinder, A. S 2010. Quantitative easing: entrance and exit strategies, Center for Economic Policy Studies, Princeton University, Princeton, NJ. Boyes, W. J., & Melvin, M 2013. Economics, Cengage Learning South-Western, Australia. Burns, R. N., & Price, J 2009. The global economic crisis and potential implications for foreign policy and national security, Aspen Institute, Washington, DC. Callen, T., & Ostry, J. D 2003. Japans lost decade: policies for economic revival. Davies, H., & Green, D 2010. Banking on the future: the fall and rise of central banking, Princeton University Press, Princeton, N.J. Fasano-Filho, U., Fasano-Filho, U., & Wang, Q 2002. Bank of Japans Quantitative and Credit Easing Are They Now More Effective, International Monetary Fund, Washington, D.C. http://proxy.library.carleton.ca/login?url=http://www.elibrary.imf.org/view/IMF001/12404-9781475502473/12404-9781475502473/12404-9781475502473.xml. HöRmann, M., & Schabert, A 2011. When is quantitative easing effective? Klyuev, V., De Imus, P., & Srinivasan, K 2009. Unconventional choices for unconventional times credit and quantitative easing in advanced economies, International Monetary Fund, [Washington, D.C.]. http://www.imf.org/external/pubs/ft/spn/2009/spn0927.pdf. Rochon, LP 2011. Monetary policy and central banking, Elgar, Cheltenham. Skene, L 2009. The Impoverishment of Nations the Issues Facing the Post Meltdown Global Economy, Profile Books, London. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=516510. Taylor, J. B., & Weerapana, A 2012. Principles of economics, South-Western Cengage Learning, Mason, OH. Read More