Until very recently, Central Banks generally conducted their monetary policy through changing their key reference interest rate, which was generally the rate at which they would lend to the commercial banks on a short term basis supported by acceptable collateral. Thus the economy was regulated by changing the price of money. Theoretically, by increasing the rate of interest in the economy, the desire to borrow and spend would be reduced and the desire to save would be increased, and economic growth and inflation should fall back. Conversely, reducing interest rates should help to boost economic growth. It is generally accepted by monetary economists that the impact of changing interest rates takes between one and two years to have its full effects on the economy.
However in late 2008, the shock to the global economy from the financial crash that most Central Banks cut interest rates to the lowest practical levels (somewhere between zero and 1%, depending on the system), but still felt that they needed to ease policy further to offset the strong recessionary forces that were being experienced.
Thus, they turned from easing through changing the price of money in the economy to easing through changing the quantity of money in the economy (hence the rather ugly term “Quantitative Easing” (“QE”)). The Federal Reserve and the Bank of England began their QE programmes in April 2009, but in fact the Bank of Japan had been engaging in QE policies since 2003, its rates having reached zero in the previous global downturn.
Until this century, QE had only ever been seen as a theoretical tool in the Central Banker’s arsenal. It was a lesson that some (most notably Ben Bernanke) learned from the Great Depression, where once interest rates reached a low point, the Central Banks felt that there was nothing else they could do. There is thus no history or experience to examine to determine if it works or how it works. The current policy is therefore a live economic experiment.
The manner in which Central Banks have indicated they expect QE to work is as follows. The Central Bank goes into the financial markets and buys securities, typically government bonds, although the Federal Reserve has also bought mortgage-backed securities, and the Bank of Japan has also bought equities and REITs. To finance this they create the money (digitally) and use it to pay the seller of the security (typically a bank). The bank’s assets now consist of more cash and less securities. Typically the income return on the cash will be lower than the income return on the securities they have just sold, and so they have a decision to make. They could choose (i) to maintain the lower income stream, because they might have a great need for liquidity, (ii) to go back into the securities markets and buy some other securities to maintain their income, or (iii) increase their lending to companies or households. Choosing (i) has no impact on the real economy and choosing (iii) clearly has a major impact because it is helping directly to boost demand and spending in the economy.
In practice, what has happened is that banks have chosen (ii), and have sought to maintain their income stream by investing in higher-risk securities. Thus yields have fallen first on government bonds, then on investment-grade corporate bonds and finally on high-yield bonds. This then gives companies the opportunity to borrow at lower rates of interest in the financial markets, which could be used to fund investment. QE, to date, has been a policy that has clearly supported financial markets – it is difficult to see a direct effect on bank lending and economic growth, but it is likely (and claimed by the Central Banks) that economic growth would have been much weaker without QE.
There are some problems with continued applications of QE. Firstly, it is generally believed by economists that QE policies have less impact as they are repeated. Since it is such an unusual policy, the first time it is deployed it has a shock effect, but later iterations do not as the financial system adapts its behaviour to the policy. Secondly, the liquidity of the underlying financial markets may be damaged. For example, the Bank of England now owns more than one-third of all gilts outstanding, and has no current plans to sell them, so the level of liquidity in the gilt market has been reduced by the policy.
The great fear that many commentators have about QE is that by creating more and more money in the financial system without greater economic output, the end result must inevitably be higher prices. In fact higher expected inflation is one of the objectives of the policy, since if people expect higher prices in the future it is rational to buy things now before they rise in price, and so boost demand in the economy today. The response of the Central Bankers would be to say that QE is a reversible policy, and the bonds that they have purchased, can very easily be sold back into the financial markets, so reducing the excess liquidity in the system, and the inflationary threat.
To date, a more realistic concern has been that there is no evidence anywhere in the world where QE has worked. It clearly has not brought Japan out of its long term stagnation, and so far neither the US or UK economies can be said to have recovered strongly. The reason for this is that the extra liquidity generated has remained within the financial system and not found its way into the real economy, and so boosted real demand. If the underlying causes of weak economic growth are that the banking system has overlent relative to its capital, that consumers feel their debt levels are too high, and both feel that they need to retrench (or in the jargon, deleverage their balance sheets), then the current policy of QE will not actually affect the desire to borrow or to lend.
A more radical policy option would be to print money and ensure that it was only used in ways that directly benefitted the consumer’s balance sheet. Thus £450 billion (only a little more than the total QE to date) could be used to give every adult in the country £10,000 to be used either to repay debt, or towards a deposit for the purchase of a first home or into a pension pot. By improving the savings to debt ratio of each adult in the country, the time at which they will once again feel happy to spend more will be brought forward.