Quantitative Easing
Yanwei Ge
‘The US will make little progress tackling high unemployment before 2014 unless the Federal Reserve eases policy further’, one of the central bank’s leading officials has warned in the run-up to a meeting next week where the option of QE3 will be on the table. It also considered the case for cutting interest rates below 0.5%, but decided it was a less attractive tool than QE. Currently, during the still- running gloom period of world economy, people start to comment on quantitative easing more often. Along with the setting of interest rates, quantitative easing (QE) is one of the monetary policies available to governments. After the 2008 financial crisis, the Bank of England (BOE) slashed its bank rate to 0.5% in March 2009 and the Federal Reserve (Fed) has held its 0%-0.25% federal funds rate since December 2008. There is hardly any room for manoeuvring the base rate in an effort to resurrect the economy. Although it has reached its record low, there is still concern about its effectiveness. (The base rate is the cost of borrowing from central bank to commercial banks.) However, commercial banks are sceptical about the current economic situation and repaying ability of borrowers, as they suffered hugely during the subprime mortgage crisis. They set up much higher interest rates as a barrier and tougher requirements in order to guarantee loans are repaid and to make profit. Currently, the average mortgage rate in Britain is above 4% and the outstanding loan to private non-financial corporate is higher than 3%, i.e. both are well above 0.5%. The unwillingness to lend out tends to block the circular flow of income, and thereby to harm the recovery from the economic trough. QE is considered as an unconventional monetary policy. The central bank creates money electronically via expanding its own balance sheet through an increase in its liabilities, not by directly printing money. The money is used to buy assets whose risks are low, such as government bonds and high-quality corporate bonds. Once new money is injected, the monetary base is expanded. Part of this increased money supply should flow into commercial banks, so they should be more willing to lend to households and firms. Not only should the quantity of money supply increase, but also the cost of borrowing should be driven down. As the new money is spent on the financial assets, this action should push up the price of assets as they become more favourable. The yield of assets should subsequently drop. This means that people who hold the assets should be wealthier directly and the cost of borrowing should be reduced. As a result, both consumption and investment should be boosted. Theoretically, by implementing this strategy the economy would regain its confidence and walk out of the doom and gloom. This increasingly popular policy is a relatively new tool. It was first used in Japan in early 2001. From the 1990s to the first decade of the new century, the Japanese economy fell enormously due to the burst of the asset price bubble; 23% of its national income was wiped out between 1990 and 2003; unemployment remained at a high level, rising to around 4-5% compared to 1-2% in the 1970s and 1980s), and price levels dipped into deflation. Thereafter, the Bank of Japan (BOJ) loosened its monetary policy, and kept its base rate close to zero for a long period of time. The introduction of this unprecedented policy at this point was to reinforce the zero interest rate policy (ZIRP) for enhancing the level of spending. The policy consisted of three main commitments, including pushing the core consumer price index (CPI) above zero per cent, changing the main operating target for money market to outstanding current account balances (CABs) held by financial institutions at the BOJ, and increasing the amount of outright purchases of long-term Japanese government bonds (JGBs). The BOJ responded aggressively to the liquidity trap which was the one of the main causes of the crisis. The target CABs was once adjusted upwards to 30-35 trillion yen (US$270-315 billion) and the monthly purchase of long-term JGBs reached its peak value at 1.2 trillion yen (US$10.8 billion). In
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