The Federal Reserve's second round of quantitative easing in 2010

¶ … Easing

In early November 2010, the Federal Reserve in the United States announced what has been termed a second round of quantitative easing, a seldom-used instrument of monetary policy. The technique is controversial and many feel risky, but the Fed believes that given the economic situation, this round of quantitative easing was necessary to help stimulate the American economy. The underlying economic situation was indeed challenging -- high unemployment, slow GDP growth and interest rates up against the zero bound. With many of the more conventional monetary policy tools unavailable and fiscal policy tools unviable politically, the move to quantitative easing was made. Despite the risks associated with the tool -- higher inflation and currency devaluation -- quantitative easing is a necessary form of monetary policy to prevent economies from experiencing deep recessions, because its stimulative effects can cause banks to lend, which allows businesses to obtain credit for equipment purchases, employing new workers, and reducing export costs as well.

The underlying macroeconomic environment can be characterized as a prolonged recovery from recession. A recession is defined as a period where GDP is falling economic activity spread across the economy, lasting more than a few months and visible in a number of indicators including real GDP, real income, employment, industrial production and wholesale-retail sales. According to the NBER (2010), the recession that ultimately led to the use of quantitative easing lasted from December 2007 to June 2009. In the period since that point, the economy has been in a slow recovery. The NBER does not differentiate between recessions and depressions in its terminology (NBER, 2011).

Another important definition in this discussion is that of inflation. Broadly speaking, inflation is the degree to which the price of goods and services changes in an economy over a given period of time. There is considerable debate among economists as to the precise measures of inflation that have the most validity when discussing the state of the economy. Mankiw (2003) argues that the best measures of inflation incorporate primary sticky information -- prices that once changed are likely to remain changed -- and that inflation can be related to expectations of future movements in the state of the economy. The latter point is important in understanding the merits and critiques of quantitative easing.

Quantitative easing is itself a controversial term. Bernanke argues that QE refers to policies that seek to change the quantity of bank reserves, while his recent program -- that was dubbed QE2 in the media -- refers to the purchase of $600 billion in U.S. bonds as a means to inject money into the banking system (Robb, 2010). The Bank of England disagrees, and explains quantitative easing as a policy where the central bank buys assets -- either government bonds or private bonds -- as a means of injecting money into the banking system and thereby the economy as a whole (Bank of England, 2008).

By whatever name, the practice of buying assets in order to inject capital into the economy is controversial because some of the impacts of such a policy have on the economy. On the positive side, the underlying theory of QE is that with more money in the banking system, the banks will be better able to lend, spurring growth. The downside -- from the perspective of some -- is that the policy will result in runaway inflation and currency devaluation (Ugai, 2007). This paper will analyze both the positive and negative impacts of a quantitative easing policy as defined by the Bank of England, and will argue that such a policy is necessary in the current U.S. economic climate to spur growth. The conditions of the liquidity trap in particular make the use of this relatively unconventional policy a necessity.

Lending from Commercial Banks

Each of the three main elements of central bank monetary policy serves to increase or decrease liquidity in the economy. The most common policy -- interest rate policy -- was utilized by the Federal Reserve at the outset of the recession. This pushed interest rates up against the zero bound. While this created a stock of very affordable money, it was insufficient to pull the economy out of the recession and effectively took interest rates off the table as a monetary policy lever. This leaves reserve requirements and quantitative easing as mechanisms for implementing expansionary monetary policy.

The quantitative easing policy sees the central bank buy bonds from intermediaries in the banking system. Money therefore enters the system, increasing bank liquidity. This practice should spur greater lending on the part of banks, which in turn would increase the amount of money for companies and consumers. Interest rates are already low, so the increased liquidity should in theory spur economic growth. In the current situation, there is an important risk to consider -- that the current economic climate is the result of a demand shock rather than a supply shock. The initial recession may have been the result of a supply-side shock -- the credit crunch -- but earlier monetary policy may have effectively resolved that shock. It is possible that what remains is a demand shock where consumers are not spending, leaving businesses with unused capacity. This effectively discourages investment, no matter how cheap the money, as businesses simply do not expand when they already have excess capacity. The possibility of a demand-side shock illustrates one of the significant risks of quantitative easing -- one that Ben Bernanke himself once alluded to in a 1988 paper -- that what intermediaries do is special and any rationing on their part may undue the desired impacts of monetary stimulus. Thus, the central bank can use a policy of quantitative easing on the expectation that it will improve liquidity in the economy, but the policy is risky in part because rationing on the part of financial intermediaries -- rather than liquidity -- is at the core of the economic stagnation.

If it is assumed that there are liquidity issues in the economy that are stalling the recovery, then the quantitative easing policy is a valuable tool. The United States Chamber of Commerce (2010) argues that by improving small business access to capital, more jobs can be created. Even if there is a demand-side shock that is inhibiting investment, quantitative easing's impact on the value of the dollar could help to stimulate small businesses that are active in export markets. Bean (2010) further argues that the purpose of quantitative easing is partly to ensure that both businesses and consumers have access to credit when they need it -- that a recovery is not stalled by poor access to credit. This line of thinking underlies the decision by the Federal Reserve to spread out its quantitative easing and why the Bank of England (2010) argues that a transparency is critical to the success of any quantitative easing policy.

The arguments made by both the Bank of England and the Federal Reserve highlight another of the important considerations with respect to the use of quantitative easing -- the policy is partly about impacting the expectations that the market has with respect to the future availability of credit. A QE policy, therefore, not only serves to inject capital into the economy but to send a signal that the central bank intends to continue to inject capital, thereby shepherding the economy out of the recession and ensuring no relapse occurs. Ugai (2007) further argues that quantitative easing creates the expectation of inflation. This creates demand in the economy for spending today before rates rise, and that demand takes advantage of the capital that has newly been injected into the economy. Ultimately, it is the expectation of inflation that brings interest rates away from the zero bound. Such a move has long-run risks related to inflation and the timing of rate decreases, but it also restores the ability of the central bank to use its most conventional monetary policy tool -- interest rates -- something it cannot do when nominal rates are near zero.

Job Creation

Bernanke & Reinhard (2004) argued that recessions typically constitute an adverse feedback loop in which economic weakness and financial stress are mutually reinforcing. Applied to the recent U.S. recession, the bursting of the housing bubble and subsequent credit crunch contributed to the creation of this type of feedback loop. Without access to capital from the banking system, businesses began to undertake contractionary activity. Anecdotal evidence at the time suggested that companies were unable to acquire the credit they needed to expand, and this lead directly to economic contraction. With contraction underway, unemployment began to rise and the demand shock was initiated. It was in this manner that the original feedback loop was created. The implication of Bernanke and Reinhart's assessment is that another shock is required to end the reinforcing feedback loop and turn the economy back in the right direction. Injecting money into the financial system would have the effect of spurring demand among consumers and businesses. Over time, this demand would lead to the reduction of unemployment.

The timing of the quantitative easing is therefore essential. The first round of QE in 2009 essentially served the purpose of stabilizing the economy; the second round is intended to sustain the ongoing economic recovery by providing sufficient capital in the system that the positive momentum generated in the economy will eventually become a feedback loop of its own that results in the restoration of GDP growth and a reduction in the unemployment rate.

To analyze the effectiveness of this strategy, the case of Japan can be analyzed. The Bank of Japan's QE policy, which was aggressive in nature, resulted in creating strong liquidity in the Japanese economy. Market expectations of inflation were impacted as well. However, the Japanese experience did not result in improving job creation. In these Japanese experience, the stimulative effects of quantitative easing did not extend beyond the stabilization of the financial sector, "suggesting that the transmission channel between the financial and non-financial sectors had been blocked" (Shiratsuka, 2010). In the United States the most recent round of QE, which is ongoing, is timed at a point when recovery has already been stimulated by fiscal policy, with the objective of maintaining momentum that already exists. The Japanese experience did not have this momentum, so the impacts of the QE were less successful at addressing the nation's unemployment rate. The Japanese experience tells us that the timing of the QE is important, because there needs to be efficient flow of capital through the intermediaries into the economy in order for the policy to create jobs.

Export Costs

One of the most important impacts of a quantitative easing program is the effect that it has on the value of the currency. By increasing the supply of money in the economy, the currency is effectively devalued. This strategy works in particular when the business cycles of the economies in question are not synchronized. If the business cycles of the countries are closely synchronized, then the positive impacts resulting from exchange rate devaluation are limited. When business cycles differ, there is opportunity to spur exports by lowering the exchange rate. As quantitative easing has the impacting of devaluing the currency, it becomes a mechanism to lower the exchange rate (Borio, English & Filardo, 2003). Thus, the U.S. dollar should be lowered against major world currencies as QE is implemented, improving the competitiveness of exporters. Of particular interest is the impact of QE on the dollar-yuan exchange rate. As the Chinese government attempts to combat a rise in the yuan's value, its task is made more difficult by quantitative easing, putting additional pressure on China to allow the yuan to appreciate, a move that would help the U.S. trade balance but would do economic harm to China (Feldstein, 2010).

Conclusion

Quantitative easing can be an effective tool of monetary policy for pulling the economy out of recession. Typically QE is only used when other tools are for whatever reason ineffective. In the current situation in the U.S., fiscal policy is a non-starter and interest rates are at the lower bound. While normally low interest rates would spur investment, reduce unemployment and lead to inflation, that has not been the case because the current situation is a liquidity trap, where the increase in liquidity required to restore full employment is more than can be achieved by lowering the interest rate alone. That quantitative easing is a relatively unconventional policy is a critique of the technique, but it should not be -- it is only unconventional during conventional times. During times of liquidity trap, quantitative easing has been used in the past and is particularly necessary when appropriate fiscal policy response is not forthcoming.

The impacts of quantitative easing on the economy are numerous, and each impact serves to perform a specific role leading to economic recovery. The first such impact is that is injects more liquidity into the system. That the current high level of liquidity is as yet ineffective is not a case against quantitative easing -- the relationship between liquidity and employment still exists -- it is an argument for quantitative easing as a means of delivering a higher level of liquidity than is typically available from interest rate policy alone. With an increase in the level of liquidity in the economy, banks are better able to lend and this will eventually spur more business investment and consumer spending. The timing of the policy is important because the channels by which this liquidity flows through the intermediaries in the financial system to the general economy need to be relatively efficient. At the outset of the recession, these channels were constrained by a combination of bank choice, ugly bank balance sheets and business concerns about demand, but many of those problems have been more or less resolved by this point, which means that QE should be more effective.

Jobs are created with QE via three key mechanisms. Increased liquidity is important, as is the decline in the value of the dollar. In addition, jobs are created because QE creates expectations of future inflation. These expectations should spur investment today to get in front of the rising rates that will follow inflation. It is this investment that will begin to create jobs. The investment dovetails with the stronger export competitiveness that comes from a weaker dollar and it also dovetails with the increase in liquidity in the banking system and the economy in general.

Because quantitative easing increases the supply of money in the economy, it serves to devalue the dollar. This approach works to stimulate demand for products on export markets by making those products more affordable. This in turn spurs business investment and job creation, even in situations where domestic demand remains suppressed. That suppression of domestic demand will be broken as a result of the increased investment by exporters. For this to work, markets need to believe that the QE policy will be ongoing, so that forward exchange rates reflect a relatively permanent devaluation.

In normal times, the risks associated with quantitative easing may be too great. However, during a liquidity trap -- in particular one with limited hope of fiscal policy response -- quantitative easing is a necessary tool for the prevention of deeper recessions. It has stimulative effects for a number of reasons, namely that it injects liquidity into the banking system, spurs business investment and creates jobs particularly in export industries. These impacts work together to create economic stimulation on many fronts. In the current American context, that the economy is now out of recession and in a state of slow recovery, that there appears to be few constraints between financial intermediaries and borrowers, and that the central bank understands how to deal with the risks of this strategy, makes it a highly effective tactic that should help to pull the economy forward and restore historic unemployment rates.

Works Cited:

Bean, C. (2010). Your Questions Answered on Quantitative Easing. Bank of England | Monetary Policy | Quantitative Easing Explained | Ask the Deputy Governor. Retrieved March 26, 2010, from http://www.bankofengland.co.uk/monetarypolicy/qe/askqa.htm

Bernanke, B. & Blinder, a. (1988). Credit, money and aggregate demand. NBER Working Papers. Retrieved March 26, 2011 from http://www.nber.org/papers/w2534.pdf

Bernanke, B.S., & Reinhart, V.R. (2004). Conducting monetary policy at very low short-term interest rates. American Economic Review, 94(2), 85 -- 90.

Borio, C.E.V., English, W., & Filardo, a. (2003). A tale of two perspectives: old or new challenges for monetary policy? BIS Working Papers No. 127. Bank for International Settlements. Retrieved March 26, 2011 from http://ideas.repec.org/p/bis/biswps/127.html

Feldstein, M. (2010). Quantitative easing and the renminbi. Project Syndicate. Retrieved March 26, 2011 from http://www.project-syndicate.org/commentary/feldstein30/English

Krugman, P. (2000). Thinking about the liquidity trap. Journal of the Japanese and International Economies. Vol. 14 (2000) 221-237.

Mankiw, G.; Reis, R. & Wolfers, J. (2003). Disagreement about inflation expectations. NBER Working Papers Series. Retrieved March 26, 2011 from http://bpp.wharton.upenn.edu/jwolfers/Papers/Disagreement.pdf