In normal times central banks move short-term interest rates via “open-market operations”: by buying or selling securities, they supply or subtract reserves from the banking system. The quantity of reserves that banks hold is a secondary consideration; the real target is the interest rate. A lower rate, for example, encourages spending and investment, boosting the economy. In times of severe economic distress, however, rates may fall to zero. Cue QE. When the Bank of Japan (BoJ) pioneered QE in 2001, its goal was to buy enough securities to create a desired quantity of reserves (hence, “quantitative easing”). Its actions, it hoped, would raise asset prices and end deflation. (via Quantitative easing: QE, or not QE? | The Economist)
- QE has now come to refer to several flavours of asset-purchase programme. One version is often called “credit easing”. The aim is to support the economy by boosting liquidity and reducing interest rates when credit channels are clogged. The Fed’s purchases of mortgage-backed securities, demand for which weakened sharply during the financial crisis, fall into this category.
- Another type of asset purchase aims to boost the economy without creating new money. The Fed’s ongoing “Operation Twist” is an example: the Fed sells short-term debt and uses the proceeds to buy long-term debt. Giving investors cash for long-term debt should prompt them to invest more money in other assets.
- QE proper is a third type. The most straightforward way this is meant to help the economy is through “portfolio rebalancing”. The investors who sell securities to the central bank then take the proceeds and buy other assets, raising their prices. Lower bond yields encourage borrowing; higher equity prices raise consumption; both help investment and boost demand. To the extent that investors add foreign assets, portfolio rebalancing also weakens the domestic currency, fuelling exports.
- If a central bank is expected to hold on to the government debt it buys, then QE can also support the economy by cutting government-borrowing costs and reducing the future burden of taxation. It can work by changing expectations, too. A promise to keep short-term interest rates low for a long time may be more credible if it is accompanied by QE, since the central bank is exposing itself through its holdings to the risk of a rise in interest rates.
Yet in the minds of many critics, even such gains do not justify the risks, great and small, of large-scale asset purchases. Three dangers stand out.
- The first threat is to the function of some financial markets. The Bank for International Settlements (BIS) argued in its recent annual report that huge growth in bank reserves was driving overnight-lending rates to zero, causing the market for unsecured overnight lending to atrophy. Since the unsecured overnight rate has been the principal policy lever for central banks, this development could, the BIS warns, make it hard for them to rein in inflation in the future. The risk can be mitigated, however. In late 2008 the Fed began paying interest on the reserves held by banks over and above the minimum required. Raising the rate of interest paid on excess reserves can make new bank loans less attractive, thus tempering overall credit creation. This tool represents a means to check inflation despite the breakdown in unsecured markets.
- A second risk from QE is of distortions in the market for government debt. The borrowing costs of some governments are extraordinarily low—an auction of ten-year Treasuries on July 11th produced record-low yields. A flight to safety is a contributing factor, but it seems that markets either anticipate decades of abysmal economic growth, or the risk premium for holding long-dated bonds is unsustainably low, thanks in part to central-bank purchases. Any adjustment may be sudden and have unpredictable consequences.
- A related concern is that QE is reducing market pressure on sovereigns that would otherwise face higher interest rates and a corresponding need to deal responsibly with their public finances. This is not a concern to take lightly. A central bank can lose control over inflation if the market has lost confidence in the sovereign and the bank is forced into buying government debt. On the other hand, a central bank that neglected its duties to play fiscal watchdog could risk its independence.