Easing in Early November 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).

Criticisms

There appear to be two primary criticisms of quantitative easing. The first is that the policy is unconventional, and therefore should not be used. While it is true that QE is a little-used instrument of monetary policy, it is not so unusual that it should not be tried. This objection does not reconcile with the fact that the Federal Reserve has a number of different tools at its disposal to implement monetary policy, of which QE is just one. The characteristics of the U.S. economy at present -- and especially last fall -- are that of a classic liquidity trap in which zero interest rates are insufficient to produce full employment (Krugman, 2000). This implies that conventional monetary policy in the form of lowering interest rates has already been attempted and is insufficient. It is in this context that quantitative easing is normally used, the classic example being Japan in the late 1990s.

The second criticism of quantitative easing reflects the risks inherent in the strategy. The strategy is criticized for achieving precisely what it intends to achieve -- increasing inflation and devaluing the currency. The currency devaluation argument is usually only conducted on moral grounds -- that devaluing the currency is bad because it is. The economic case for devaluing the currency is apparent from the basic GDP accounting identity: GDP = C + I + G + (X-M). At times when quantitative easing is typically attempted C. And I have not been sufficiently stimulated by interest rates at the zero bound. Fiscal policy has either been proven ineffective or is for one reason or another political infeasible. This leaves X-M as the sole remaining way of improving economic prospects. There are mechanisms by which the balance of trade can be impacted, but many such mechanisms either fall within the realm of fiscal policy, are long-term in nature or both. For the central bank, the ability to influence exchange rates through a policy of quantitative easing is essentially the best tool at its disposal. By devaluing the currency, exports will be encouraged and imports discouraged. This will have the impact of improving the GDP, and this policy will also serve to encourage business investment. This tactic is especially useful in a situation like the present where a demand shock is at least in part responsible for the economic malaise, because currency devaluation helps to stimulate demand on the export markets.

In addition, by bringing export markets into the equation, Bernanke's feedback loop is effectively broken. The feedback loop is based on the economy being relatively contained within the nation's borders -- that is to say the (X-M) equation is largely unchanged during the course of recession and recovery. Quantitative easing is one of the most effective -- and more importantly one of the most immediate -- ways of addressing the (X-M) portion of the GDP identity.

Another key risk cited as a reason not to undertake quantitative easing is the risk of inflation. The policy is designed to spur an increase in inflation in order to allow interest rates to break off of the zero bound. This in turn gives the central bank another tool with which to address the state of the economy. In addition, it should be noted that central banks tend to aim for inflation rates around 2% annually, and for that rate to be held stable. In the current context, inflation rates are much lower, and core inflation has been trending towards deflation. The Japanese situation illustrates some of problems with deflation, including the fact that in a deflationary environment money becomes a substitute for bonds; in a liquidity trap environment they are effectively substitutes for one another, which is bad enough. Bernanke (2009), the Bank of England (2008) and others argue that because the central bank controls the levers to contain inflation, that it is well positioned to address inflation when it becomes too high. Economists are generally in agreement that inflation will rise with quantitative easing, the main issue is when to contain inflation.

Bernanke admits that controlling inflation after a quantitative easing round requires delicate handling of the issue. Because the QE has increased inflation expectations among investors, it is likely that inflation will lead the actual recovery, in particular the unemployment rate. Therefore, the central bank is likely to have to deal with inflation before the recovery is complete. The underlying theory is that rates will be raised when the inflation rate gets above the central bank's target rate. The Fed may need to raise rates quickly in order for this to happen. While it is agreed that the raising of rates needs to be done delicately in order to send the right signals to the market that the inflation situation in under control and the economic recovery will continue, the risks that this is not done effectively are generally considered worthwhile in order to pull the economy out of its recession.

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.