Basics of quantitative easing

Talks of QE-II build up (infact market people are now debating how much of QE not whether there will be QE. It is being called Bernanke Put).

Alan Blinder presents a nice primer on quantitative easing in this year’s Homer Lecture at St Louis Fed. He summarises what happened in US and then comapres it with Japan.

This lecture begins by sketching the conceptual basis for QE: why it might be appropriate, and how it is supposed to work. I then turn, first, to the Fed’s entrance strategy—which is presumably in the past, and then to the Fed’s exit strategy—which is still mostly in the future. Both invite some brief comparisons with the Japanese experience between 2001 and 2006. Finally, I take up some questions about central bank independence raised by quantitative easing before briefly wrapping up.

According to Blinder, QE-I can be divided into two phases. First phase was inconsistent and responding to crisis. In first phase, Fed just exchanged assets. It replaced trasuries on its portfolio with risky assets in the market. Hence, there was no expansion of balance sheet.

In second phase which bean after Lehman Fed was more creative and smart. Seeing the crisis, it expanded the balance sheet by buying assets and expanding the bank reserves.

Comparing to Japan:

Quantitative easing in Japan, the only relevant historical precursor, began in March 2001 and ended in March 2006. (See Chart 8.) The Bank of Japan (BoJ) drove the overnight interest rate to zero and then pledged to keep it there until deflation ended, mainly by flooding the banking system with excess reserves. To create all those new reserves, the BoJ bought mostly Japanese government bonds (JGBs). As mentioned earlier, the central idea behind QE in Japan was to stimulate the economy by proliferating reserves and flattening the (risk-free) yield curve, not by decreasing risk spreads.

In fact, long bond rates did fall. But it is difficult to know how much of the decline was due to the BoJ’s purchases and how much was due to its pledge to keep short rates near zero for a long while. A survey of empirical research on the effects of Japan’s QE programs by Ugai (2006) concluded that the evidence “confirms a clear effect” of the commitment policy on short and medium-term interest rates but offers only “mixed” evidence that “expansion of the monetary base and altering the composition of the BOJ’s balance sheet” had much effect.

 The main problem was BoJ sudden exit from its balance sheet:

In any case, one of the more interesting and instructive aspects of QE in Japan may be how quickly it was withdrawn. Chart 8 shows that banks’ excess reserves climbed gradually from about 5 trillion yen to about 33 trillion yen over the course of about two and a half years, but then fell back to only about 8 trillion yen over just a few months in 2006. Such an abrupt withdrawal of central bank money was, I suppose, driven by fears of incipient inflation, which was curious given Japan’s recent deflationary history; in any case, inflation never showed up. While the suddenness of the BoJ’s exit did not kill the economy, whether it damaged the Japanese economy’s ability to stage a strong recovery is an open question.

In the case of the Fed, the massive increase in bank reserves after the Lehman bankruptcy came very quickly, as Chart 3 showed. The shrinkage, of course, has yet to begin. But my guess is that it will be gradual. If so, the Fed’s pattern (up fast, down slow) will be just the opposite of the BOJ’s (up slow, down fast). My second guess is that the Fed’s more gradual withdrawal of QE will not unleash strong inflationary forces. And if that is correct, my third guess follows: History will judge the Fed’s course the wiser one. But all this is in the realm of conjecture right now. History will unfold at its own pace.

 Hmm. Only future research will show whether QE worked or not. And now we might have QE in few more phases.

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