Growth in the time Quantitative Easing!

https://www.dropbox.com/s/sf95mgnfpo4o9i0/Liquidity%20Trap.png?dl=0Background:

In my blog post – ‘How FED talks affect the rest of the world!’ I discussed the impact of ‘QE taper talks’ on bond market returns. In this post I will outline how the policy of QE (Quantitative Easing) has been adopted by most advanced economies to boost aggregate demand and in turn promoted stronger economic recovery. The example of Japan -  ‘Abenomics’ which is  Shinzo Abe’s take on implementing QE as a part of the multi-pronged approach he adopted to revive Japanese economy after two long decades of deflation.

Traditionally, Open Market Operations (changing money supply by purchasing or selling government bonds) constitute  the most important tool through which central banks intervene to control interest rates and in the process asset prices and credit channels. However in the face of zero lower bound (the target rate such as the FED funds rate hovering around zero) conventional monetary policy fails and the economy is stuck in what is described as the liquidity trap.

Faced by a liquidity trap, conventional monetary policy fails to deliver as changes in money supply can no longer stimulate changes in economic activity. QE is the process by which central Banks create money by purchasing government securities such as treasury notes and asset backed securities and in process inflating its own balance sheet and creating cash in the form of excess reserves. This ‘new money’ channelled into the banking system encourages lending, in process investment and spurs economic activity.

The aftermath of the great recession witnessed QE being executed by advanced economies such as US and UK to boost the sluggish economic recovery. jp/en/%20">BoJ adopted QE in various phases receiving maximum impetus under Shinzo Abe.

Different Central Banks - Different Approaches to QE:

The following lists the different channels through which QE was implemented across the major economies/institutions

• ECB, on Oct 2008, announced FRFA - Fixed-rate Full-Allotment Tenders - offered when earlier LTROs – Long Term Refinancing Options had failed to stimulate the economy. Under FRFAs the full amount of liquidity requested by the banks is refinanced against a broader list of eligible collaterals. This was the first time that ECB reversed its policy of offering a fixed allotment of funds at rates decided by a bidding process.

• FED carried out asset purchases such as Government Sponsored Enterprise debts (GSE) and MBS - Mortgage Backed Securities and LSAP - Large Scale Asset Purchases. Till date, the FED had extended four rounds of QE. QE1 and QE2 have been phased out. QE3 and QE4 are still being carried out but both are in the process of being tapered i.e. scaled down.

• BoE, initially reluctant to extend QE, initiated the APF or the Asset Purchase Facility. The APF was a private asset purchase program used as a tool for easing the corporate credit channel. Asset purchases under APF were matched by sale of short term gilts (low risk bonds issued by HM treasury) - so initially the monetary stimulus did not start as QE. Subsequently BoE undertook QE operations and financed asset purchases under APF by printing money and in process attempting to achieve nominal demand required for attaining the inflation target.

• jp/en/%20">BoJ initially issued SFSO/Special Funds Supplying Operations - similar to the lending operations carried out by ECB. The operation extended unlimited amounts to banks at the near zero uncollateralized overnight call rate of 0.3 %, similar to the policy adopted by the ECB. Collaterals under SFSOs consisted of commercial paper and corporate debt.

The image has been taken from an article published on Quantitative Easing by the Economist.

The graphic depicted above indicates that across most economies QE was accompanied by signs of recovery and GDP growth. Weaker signs of recovery in the Euro zone can be attributed premature spike in interest rate in 2011 and lack of political will and support for QE from stronger economies such as Germany.

QE and ‘Abenomics’

BoJ phased out the SFSOs in Apr’10 and replaced the same with FROs or Fixed Rate Operations. In Dec’10 BoJ announced a significantly more comprehensive approach to monetary easing. The main focus being to lower long term interest rates and risk premium and in process lead to lower short term rates and lower expectations eventually culminating to a higher inflation rate.

Between 2010 and 2012 the Japanese government expanded APF (Asset Purchase Facility)/GSFF (Growth Supporting Funding Facility) like BoE, reintroduced unlimited liquidity provisions and consequently recorded relatively higher GDP first half of 2012. This however was followed by contraction in the second half. Shinzo Abe – re-elected to power in Dec’12 re-launched the QE policy on a larger scale with greater political support, along with supply side restructuring measures and focus on ‘Monetary Policy carried out with Credible Commitment’.

The early results are promising especially as core inflation overcame the hurdle of the onset consumption tax (3% sales tax was levied on all goods in April’14) and consumer spending gained momentum. As of July’14 core inflation is 1.3%. One of the major driving forces behind the relatively higher inflation is the weaker Yen which makes Japanese exports more competitive and drives growth by stimulating positive trade balance.

The Japanese example along with signs of recovery in the US and UK thus illustrates that it is normative to use QE with structural reforms in order to boost an ailing economy.

The content of the blog has been sourced from the following: Four Stories of Quantitative Easing by Brett W. Fawley and Christopher J. Neely , Japan's Tax Increase Puts Abenomics at Risk ,Quantitative Easing in Japan: Past and Present , Yen likely to weaken as BOJ continues QE, Quantitative easing Turning over a new leaf?, What is quantitative easing?,

 

 

I can all but guarantee you once QE ends you will never see it used again. With that said QE only maintained effectiveness when the BOJs balance sheet was less than 30% of GDP. Getting close to that now here, and liquidity must be paid back. Use your head, I could delve deeper but your post has zero critical thinking so there is no point.

One such question is, what are the long term implications of ZIRP policy on the insurance industry?

 
Best Response

Despite having sophisticated tools the industry as a whole could not predict the crisis (although a few economists had sent out warning signals). Having a tool to deal with unforeseen circumstances definitely helps. You have raised an important point by bringing up the balance sheet question. The effectiveness of both fiscal and monetary policy depends on the level of indebtedness a country faces. Inflating balance sheet for a country with high levels of debt might lead to adverse circumstances and a possible reason why nations like Germany have been skeptical towards using QE in the Euro area with member countries having high levels of debt. Finally, monetary policy in the zero interest rate policy situation requires communication with 'credible commitment' hence the role for forward guidance'.

 

I'm sure exploding the Fed Balance Sheet from 5% of GDP to 20% of GDP will have no long term negative consequences on savings at a time when a large demographic of the population is about to retire. And I'm sure it will not have created a misallocation of resources into riskier assets that will take years to unwind by exchanging a real estate bubble for a bubble in equities. I'm sure that it will not have implicitly devalued the currency, because everyone else is smoking the QE crack pipe as well, so where else will people run, but to the dollar and U.S treasuries? Finally, I'm also sure I'll get $5 for my loose tooth from the tooth fairy.

 

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