What macroeconomic theory has been brought to bear in evaluating the efficacy of QE? In conventional policy discourse, there are three basic theories: portfolio balance or segmented markets theory, preferred habitat theory, and signaling.
First, with respect to portfolio balance theory, when central bankers use QE, they appear to believe that purchases of long-maturity assets will make the yield curve flatter. According to portfolio balance theory, assets of different maturities are imperfect substitutes because of frictions that inhibit arbitrage across maturities—assets are costly to buy and sell, for example.
This, then, implies that the relative supplies of assets matter—a lower supply of long-term assets and a higher supply of short-term assets imply that long-term interest rates fall and short-term interest rates rise. Second, preferred habitat theory posits that financial market participants have preferences over maturities of assets. This implies a type of asset market segmentation, making the mechanism by which QE might work similar to portfolio balance theory.
Third, in signaling theory, even if there are no direct effects of quantitative easing, commitment to future monetary policy can matter for economic outcomes in the present, and quantitative easing may be a means for the central bank to commit. A central bank is a financial intermediary. And the central bank lends to the government, private financial institutions and sometimes to private consumers.
For example, the Fed indirectly holds private mortgages, which back the mortgage-backed securities in its portfolio. Like private financial intermediaries, central banks transform assets in terms of maturity, liquidity, risk and rate of return.
Therefore, the ability of a central bank to affect economic outcomes in a good way depends on its having an advantage relative to the private sector in intermediating assets. Perhaps surprisingly, none of the theories typically used by central bankers to justify QE—portfolio balance segmented markets , preferred habitat, signaling—integrates financial intermediation into the analysis in a serious way.
To see how financial intermediation theory is important for understanding monetary policy, consider how conventional monetary policy works. The primary liabilities of a central bank are currency and reserves, which play important medium-of-exchange roles in retail transactions and in transactions among financial institutions.
But we could imagine monetary systems in which the media of exchange used in transactions are the liabilities of private financial institutions, and those financial institutions create their own cooperative arrangements for executing transactions among themselves. Indeed, before the Fed opened its doors in , much of the currency issued in the U. Those notes were issued by state-chartered banks during the free banking era and by nationally chartered banks during the national banking era From to , one arrangement for interbank transactions was the Suffolk banking system, which operated in New England.
Another example of a private monetary system was the pre note-issue system in Canada, under which chartered banks issued circulating notes and the Bank of Montreal a private bank acted as a quasi-central bank. So, given historical precedent, the current functions of central banks could, in principle, be carried out by the private financial system.
But there is a presumption that such an arrangement would be less efficient than having a central bank. Indeed, in the U. The argument, enshrined in the Federal Reserve Act of , is that, in the absence of a central bank, the financial sector would be unstable and would be insufficiently responsive to fluctuations in the need for financial intermediation. The Fed was designed to stabilize the financial sector through discount-window lending in crises and to accommodate fluctuating needs for currency.
In the case of the U. Thus, the Fed was primarily transforming the debt of the U. Treasury into currency. That is, through movements in market interest rates and portfolio adjustments by financial institutions and consumers, the new reserves created by the open market purchase would end up as currency.
Thus, the Fed would have increased the quantity of intermediation it was doing, in nominal terms. Because this central bank financial intermediation was not offset by less private-sector financial intermediation of the same type, there would be effects on asset prices, inflation and aggregate economic activity. But QE is fundamentally different from conventional open market operations. QE is conducted in a financial environment in which there are excess reserves outstanding in the financial system.
Given the interest rate on excess reserves IOER , other interest rates and quantities adjust so that banks are willing to hold the reserves supplied by the central bank.
It is generally recognized that a financial system flush with reserves, as has been the case in the U. Only the deposits can actually be spent in the real economy, as central bank reserves are just for internal use between banks and the Bank of England. The problem was that the money created through QE was used to buy government bonds from the financial markets pension funds and insurance companies. The newly created money therefore went directly into the financial markets, boosting bond and stock markets nearly to their highest level in history.
In theory, this should make people feel wealthier so that they spend more. Very little of the money created through QE boosted the real non-financial economy. The Bank of Japan moved from buying Japanese government bonds to buying private debt and stocks. However, the quantitive easing campaign failed to meet its goals. Eventually, the SNB owned assets that exceeded the annual economic output for the entire country.
Although economic growth has been positive in Switzerland, it is unclear how much of the subsequent recovery can be attributed to the SNB's quantitative easing program. In August , the Bank of England BoE announced that it would launch an additional quantitative easing program to help address any potential economic ramifications of Brexit. The plan was for the BoE to buy 60 billion pounds of government bonds and 10 billion pounds in corporate debt. The plan was intended to keep interest rates from rising in the U.
This was lower than the average rate from through As a result, economists have been tasked with trying to determine whether or not growth would have been worse without this quantitative easing program.
On March 15, , the U. This decision was made as a result of the massive economic and market turmoil brought on by the rapid spread of the COVID virus and the ensuing economic shutdown. Subsequent actions have indefinitely expanded this QE action. Quantitative easing was used in by the Bank of Japan BoJ but has since been adopted by the United States and several other countries. By purchasing these securities from banks, the central bank hopes to stimulate economic growth by empowering the banks to lend or invest more freely.
Critics have argued that quantitative easing is effectively a form of money printing. These critics often point to examples in history where money printing has led to hyperinflation, such as in the case of Zimbabwe in the early s, or Germany in the s. However, proponents of quantitative easing will point out that, because it uses banks as intermediaries rather than placing cash directly in the hands of individuals and businesses, quantitative easing carries less risk of producing runaway inflation.
There is disagreement about whether quantitative easing causes inflation, and to what extent it might do so. For example, the BoJ has repeatedly engaged in quantitative easing as a way of deliberately increasing inflation within their economy. However, these attempts have so far failed, with inflation remaining at extremely low levels since the late s.
But so far, this rise in inflation has yet to materialize. Federal Reserve Bank of New York. Board of Governors of the Federal Reserve System.
Congressional Research Service. Accessed Sept. Federal Reserve Bank of St. International Monetary Fund. Federal Reserve Bank of San Francisco.
The World Bank. Swiss Society of Economics and Statistics. Bank of England. When a central bank prints money, the supply of dollars increases. This hypothetically can lead to a decrease in the buying power of money already in circulation as greater monetary supply enables people and businesses to raise their demand for the same amount of resources, driving up prices, potentially to an unstable degree.
For instance, inflation never materialized in the period when the Fed implemented QE in response to the financial crisis. Some critics question the effectiveness of QE, especially with respect to stimulating the economy and its uneven impact for different people.
Quantitative easing can cause the stock market to boom, and stock ownership is concentrated among Americans who are already well-off, crisis or not. And when the market rebounds quickly, as it did following the bear market of , the question becomes when do we say enough is enough?
By lowering interest rates, the Fed encourages speculative activity in the stock market that can cause bubbles and the euphoria can build upon itself so long as the Fed holds pat on its policy, Winter says. A final danger of QE is that it might exacerbate income inequality because of its impact on both financial assets and real assets, like real estate.
The Bank of Japan has been one of the most ardent champions of quantitative easing, deploying this policy for more than a decade. In the first rounds of QE during the financial crisis, Fed policymakers pre-announced both the amount of purchases and the number of months it would take to complete, Tilley recalls. Building on some of the lessons learned from the Great Recession, the Fed relaunched quantitative easing in response to the economic crisis caused by the coronavirus pandemic.
Policymakers announced plans for QE in March —but without a dollar or time limit. The unlimited nature of the latest instance of QE is the biggest difference from the financial crisis. Because market participants had become comfortable with this policy by the third round of QE during the financial crisis, the Fed opted for the flexibility to keep purchasing assets as long as necessary, Tilley says. Moreover, statements from policymakers reinforced that it would support the economy as much as possible, Merz says.
Yes and no say Tilley, Winter, and Merz. But once the market has stabilized, the risk of QE is that it could create a bubble in asset prices—and the people who benefit most may not need the most help, Winter says.
And the cost to this policy is significant in that it adds to the imbalances in income inequality in this country, he adds. And there are lingering concerns about the potential of relying too heavily on QE, and setting expectations both within the markets and the government, Merz says. Louis, concluded in a paper. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree.
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