Quantitative Easing Can Help to Reflate Our Economies - Assignment Example

Quantitative Easing can help to Reflate our Economies Introduction Quantitative easing (QE) is an unconventional means of stimulating national economies employed by central banks when conventional monetary policies are no longer effective. It is an expansionary monetary policy in which the central bank injects money into national economy through purchasing of public and private financial assets (Blake & Kirsanova, 2011, p. 41). Central banks often achieve this through the use of open market operations and standing lending facilities. In the past, central banks have primarily relied on monetary measures that seek to reduce interest rates during periods of recession so as to counter deflation or to raise inflation rates. However, the recent financial crisis and economic recession has posed unusual challenges to central banks, making the use of conventional policy measures to be ineffective. In several cases, central banks have reduced their lending rates to levels close to zero without realising the intended objectives. This has made it necessary for monetary authorities to use QE to stimulate their national economies and to realise the inflationary objective (Blake & Kirsanova, 2011, p. 41). In most of the economies where this policy has been employed, the key inflationary objective has been to maintain the inflation rate at a particular set target. According to Hamouda (2009, p. 20) the QE policy was used in Japan in 2001 to counter the effects of a severe depression which had hit the country’s economy for a long time. Though this policy helped Japan to stop inflation from falling down further, various issues made the policy ineffective in raising inflation to the target. However, application of this policy during the recent economic crisis by various nations such as the UK and the US has demonstrated that QE is not only a useful tool in preventing inflation from falling below the target; but it can also help to raise inflation to the target. This paper seeks to explain how QE can help to counter deflationary forces and to raise the inflation rate to the target. It examines its effectiveness in reflating our economies, drawing examples from cases of the US, the UK and Japan. Using QE to control inflation Central banks in most cases control inflation by use of use interest rates. They achieve this by pegging a specific lending rate on loans to financial institutions (Hamouda, 2009, p. 20). The central bank rate (also called bank rate) influences many other rates available to borrowers and savers in financial institutions. This affects the rate of spending by individuals and companies, which in turn affects the rate of inflation. Thus, when inflation rises or is expected to rise beyond the set target, Central banks raise their rates. This affects rates in financial institutions, leading to reduced spending and eventually, reduced inflation. On the other hand, if inflation falls or is expected to fall below the set target, central banks reduce bank rates, which helps to boost spending and to raise inflation. In some cases, inflation may become very low or it may fall to a point where it is very far below the target. In this case, central banks respond by reducing bank rates. But as the Bank of England (BoE) (2011, p. 10), points out, the interest rate may be reduced up to zero, without realising the objective of raising inflation. At this point, the central bank can achieve the reflationary objective by increasing the quantity of money circulating in the economy. This can be done through the QE process explained in the Keynesian monetary theory (Hamouda, 2009, p. 20). This model assumes that there is a direct relationship between spending and the prices of various commodities in a national economy. As such, the model suggests that increased spending can lead to a higher inflation rate while reduced spending corresponds to a low rate of inflation (Hamouda, 2009, p. 20). According to the Keynesian monetary theory, the central bank can employ a QE policy during a time of recession to raise inflation rates in a national economy. This can be achieved by directly purchasing public and private financial assets, thereby helping to boost spending in a variety of ways. First, purchasing of financial assets means that the seller will have more money in liquid form (Hamouda, 2009, p. 20). This is most likely going to stimulate them to increase spending. Also, the sellers of these assets may purchase other assets such as company bonds and shares. In this case, the prices of these assets will increase, making the owners of these assets better off. This may stimulate them to spend more. Further, according to Joyce et al (2011a, p. 113), an increase in the prices of such assets leads to lower yields, thereby reducing the cost of borrowing for households and businesses. A low cost of borrowing means higher spending rates. Purchasing of financial assets from non-bank institutions increases financial reserves in banking institutions especially due to increased deposits. Increased reserves may stimulate banking institutions to increase lending to businesses and households. Again, increased borrowing leads to increased spending. However, according to BoE (2011, p. 10), it is not always true that purchasing financial assets from banks may boost spending. Banks may hold on lending especially in cases when they feel that their financial health is at risk, such as during periods of financial crises. Another impact of the asset purchases is increased confidence. As BoE (2011, p. 10) explains, increasing the quantity of money in circulation may lead to an improved economic outlook. This is likely to boost consumer confidence and thus, raise their willingness to spend. Therefore, purchasing of assets directly by the central bank increases the amount of money held by households and businesses, raises asset prices, reduces borrowing costs, and may increase consumer confidence, thereby stimulating expenditure. Increased expenditure especially on consumer goods may lead to increased demand and higher prices. According to the Keynesian monetary model, this will result into higher inflation rates. Therefore, QE can help to raise inflation during times of recession and where convectional policy tools are unable to raise the inflation rate BoE (2011, p. 10). However, according to Joyce et al (2011, p. 113), the principles described in the Keynesian monetary model may not be effective in raising inflation in cases where there are other limiting factors, as demonstrated in Japan’s case. Japan case study According to the International Monetary Fund (IMF) (2006, p. 27), Japan started experiencing persistent deflation since the early 1990s as a result of persistent financial bubble burst. Consequently, the Bank of Japan (BoJ) reduced lending rates from 6% in 1990 to 0.5% in 1995, in a move to try to get out of the crisis. Though this policy intervention led to several recovery phases, the economy of Japan continued to deteriorate in late 1998. In response, BoJ reduced the lending rate to a level close to zero in 1999 (IMF, 2006, p. 27). As a result, prices stabilised and the economy became strong until 2001 when it started to decline and deflation worsened. The BoJ could not reduce its lending rate anymore since it was close to zero and thus, it was forced to adopt a more aggressive monetary policy. It adopted a Quantitative Monetary Easing Policy in March 2001 by purchasing long-term government bonds primarily from banks. According to the IMF (2006, p. 27) BOJ later widened the range of assets it purchased to cover other private assets held by private banks such as asset-backed securities and equities. This process provided banks with excess reserves amounting to 5 trillion yen. The process continued for several years and by October 2005 the amount of bank reserves had increased by 63 trillion yen (Meier, 2009, p. 39). BoJ significantly reduced direct purchases of assets in 2006, though the policy has been applied severally since then. The IMF (2006, p. 27) noted that the QE policy in Japan helped to improve the lending attitude for financial institutions and to create a more accommodative environment for corporate financing. However, the policy had a limited impact on the overall economy and on deflation. According to Meier (2009, p. 39), lending by financial institutions declined constantly between 1999 and 2005 in spite of the ample liquidity injected in the banking system. This has been attributed to the weak banking system in Japan during the period, which impaired the credit channel leading to loss of confidence among businesses and households. The consumer price index (CPI) rate had declined from an annual rate of 2.6% in 1990 to -1% by 2001 and has remained negative since then as shown in the following diagram: Figure 1: Japan CPI inflation rate trend Source: Koo (2011) Therefore, as a result of the aforementioned factors, the QE policy in Japan has not been effective in raising the inflation rate. The case of the United Kingdom Quantitative easing was employed first in the UK in 2009 during the period of a serious global downturn (Chadha & Holly, 2011, p. 11). The global crisis which started in 2008 was intensified by the collapse of US Lehman Brothers in September 2008, which led to collapsing of confidence in the world economy. As a result, global financial markets became dysfunctional and credit channels were impaired. During the crisis, the world GDP fell to its lowest since World War 2. According to Chadha and Holly (2011, p. 11), the UK GDP fell by 2.4% during the first Quarter of 2009. Consequently, the Bank of England’s Monetary Policy Committee (MPC) took measures to loosen monetary and support expenditure. According to Joyce et al (2011, p. 1), by the last Quarter of 2008, the MPC had already reduced its lending rate by 3% points which was followed by a further 1.5% points reduction in early 2009. By early March 2009, the MPC lending rate had been reduced to 1.2%. But MPC judged that there was risk that the reduction in lending rate would not be effective in achieving the 2% CPI inflation target. The MPC therefore found it necessary to ease monetary conditions further through a programme that would stimulate national spending (Joyce et al 2011, p. 1). MPC decided to inject money into the economy by purchasing private and public financial assets using central bank reserves, though the purchases were largely focused on UK government bonds (gilts). The small quantities of private sector assets purchased were meant to boost the amount of money circulating in the economy, thereby increasing nominal spending and help to prevent inflation rate from falling below 2%. Initially, the MPC purchased £75 billion worth of assets and the figure increased gradually to £200 billion by November 2009. With instructions from the UK government, MPC adopted additional measures, which were meant to improve the performance of specific financial markets. These measures included purchases of high-quality corporate securities and commercial paper (Rolland, 2011, p. 65). According to Gibbard and Stevens (2011, p. 105), the monetary policy measures helped to stimulate the UK GDP by between 1.5% and 2%. When MPC adopted the programme for injecting money into the economy, it was feared that inflation rate would fall below its 2% target. But a 2010 report by MPC indicated that amid higher commodity prices and tax rates, inflation shot up to 4.5% (Joyce et al, 2011, p. 1). By November 2011, the inflation rate had reached 4.8%, making it necessary for MPC to intervene to reduce it. The following figure provides the trend inflation rate since the first application of the QE policy in UK: Figure 2: UK inflation rate trend Source: Joyce, Tong & Woods (2011, p. 41) Therefore, it is clear that the QE policy has been effective in raising inflation rates in the UK. The case of the United States The US suffered its worst economic crisis in 2008 since the 1930s. This crisis resulted from the burst of a housing bubble which affected depository institutions and other financial institutions involved with housing finance in the US. The real GDP was falling at an average annual rate of 6% with approximately 750,000 monthly job losses (Duncan, 2012, p. 78). Historical rise in delinquency rates on home mortgages during the period led financial firms involved in mortgage lending to suffer loss of access to liquidity and huge capital losses. This led to the collapse of one of the biggest money lenders, Lehman Brothers in 2008, leading to a financial panic that resulted in a decline in spending and a fall in prices of key assets. Consequently, the real economy of the US and the world began to contract at an alarming rate resulting into deflation (Pozen, 2009, p. 157). The US federal bank took several extraordinary steps to rescue the situation. First, the federal bank reduced its lending rate from 5.25% to almost zero (Blinder & Zandi, 2010, p. 1). However, the economy still remained fragile and the Federal Reserve Bank found it prudent to adopt unconventional monetary policies to increase level of liquidity in the financial system. In March 2009, the Federal Bank engaged in massive quantitative easing through the purchase of $300 worth of treasury bonds and Freddie Mac and Fannie Mae mortgage-backed securities at $175 billion in order to bring down interest rates in the long-term. The purchases were completed in a period of one year. According to Labonte (2012, p. 9), this move ended the great recession in the US economy and helped to spur recovery. However, unemployment levels remained low. The Federal Reserve Bank therefore took steps to stimulate economic growth through a second round of purchasing additional treasury bonds worth $600 billion in March 2010. These purchases were completed in a period of six months (Engelen et al, 2011, p. 229). The Federal Reserve Bank report produced in 2011 showed that the with additional fiscal measures, the QE policy helped to raise real GDP by 15% to $1.8 trillion and created almost 10 million jobs, reducing the unem­ployment rate by approximately 6½ percentage points lower. Importantly, inflation rate has increased from -1% in 2009 to almost 4% in 2012, as shown in the diagram below. Figure 3: US annual inflation rate Source: Labonte (2012) Therefore, as in the case of the UK, the QE policy has helped to raise inflation rate in US. From the above case studies, there are various reasons which explain the difference in the effectiveness of the QE policy on controlling inflation rates in Japan, the UK and the US. First, unlike in the UK and the US cases, QE was applied on a dysfunctional banking system in Japan, with an impaired credit channel. According to Lenza et al (2010 p. 14), this was caused by the fact that BoJ and failed to act early enough, making consumers and businesses to lose confidence in the banking system. The BoJ had reduced lending rate to 0.5% by 1995 but did not apply the QE policy until March 2001. In the UK for instance, MPC reduced the lending rate to 0.5% in 2009 and began the programme of directly injecting money into the economy the same month (Lenza et al, 2010 p. 14). Thus, the QE policy in Japan could not stimulate spending and raise inflation rate as effectively as it did in the UK and in the US. Secondly, as noted earlier, the BoJ purchased financial assets principally from banks. Thus, there was no direct effect of the policy on spending. This makes it clear that Japan would have effectively raised inflation rates if it had applied the QE policy in a similar manner as the UK and the US and if its banking system was functional. Conclusion Therefore, drawing from the cases of Japan, UK and the US, we can conclude that QE is an effective monetary policy tool in raising the inflation rate. This policy, which is based on the Keynesian monetary model, can be applied to raise the inflation rate when conventional policy tools are ineffective to achieve this goal. However, there are external factors that may limit the effectiveness of the policy in raising the inflation rate. As noted in the above cases, the banking system and the credit channel in an economy need to be stable for this policy to work. Further, the effectiveness of the policy is affected by the consumer confidence in an economy. Finally, for the process of QE to be effective in increasing the inflation rate, it should operate in a variety of channels, with only a few involving commercial banks. Otherwise, it may be ineffective when the central bank purchases assets only from banks since the banks may hoard the money in order to increase their capital reserves. References Blake, A & Kirsanova, T 2011, ‘Inflation conservatism and monetary-fiscal policy Interactions,’ International Journal of Central Banking, Vol. 7, Iss. 2, pp. 41-83. Blinder, A S & Zandi, M 2010, How the Great Recession was brought to an end, Accessed 21 March 2011 from, http://www.economy.com/mark-zandi/documents/End-of-Great-Recession.pdf BoE 2011, Quantitative easing explained: putting more money into our economy to boost spending, Accessed 21 March 2011 from, http://www.bankofengland.co.uk/monetarypolicy/Documents/pdf/qe-pamphlet.pdf Chadha, J & Holly, S 2011, Interest Rates, Prices and Liquidity: Lessons from the Financial Crisis, Cambridge University Press, New York. Duncan, R 2012, The New Depression: The Breakdown of the Paper Money, John Wiley & Sons, Economy, Hoboken. 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