QUANTITATIVE EASING UNRAVELED: CRUCIAL HIGHLIGHTS
- Amidst rock-bottom interest rates, the Federal Reserve embarked on another policy measure through quantitative easing
- After prolonged QE implementation, the Bank of Japan witnessed dwindling economic and financial outcomes
- Likewise, the ECB resorted to long-term refinancing operations (LTROs) as a variant of quantitative easing, but uncertainties persist regarding their efficacy
HOW DOES QUANTITATIVE EASING WORK?
Quantitative easing, commonly known as 'QE,' is a monetary policy measure often utilized by central banks to invigorate their domestic economy when conventional methods have been exhausted. The central bank engages in purchasing securities, predominantly government bonds, from its member banks, thereby augmenting the money supply in the economy.
This augmented money supply leads to a reduction in the cost of money, making borrowing cheaper for businesses seeking funds for expansion. The impact is akin to the typical short-term interest rate cuts that central banks employ, but the influence of QE can extend to lower costs for significantly longer-term loans. Consequently, this could directly affect lending in various sectors such as housing, automotive, and small businesses.
THE FEDERAL RESERVE BANK (FED) QUANTITAIVE EASING POLICY
As the apex bank of the United States, the Federal Reserve bears the responsibility of furnishing the nation with a safer, adaptable, and steadfast monetary and financial framework. This purpose is frequently distilled into a declared dual mandate of stable inflation and diminished unemployment. In the quest for these goals, the Fed is endowed with an array of monetary policy instruments that empower it to sway the US Dollar and the money supply in the country. While adjusting the Federal Funds rate is the most renowned tool, the central bank's balance sheet has emerged as one of elevated significance and captivated investor attention.
FEDERAL RESERVE BANK TOTAL ASSETS
To put it simply, the Federal Reserve's balance sheet functions much like any other balance sheet. It records the assets and liabilities across all the Federal Reserve bank branches. This balance sheet can be used as an unconventional or supplementary monetary policy tool, especially when conventional interest rate adjustments have limited impact.
During the 2008 Great Financial Crisis, the US economy fell into a recession, prompting the Federal Reserve to implement a series of interest rate cuts to boost spending and stimulate economic growth. However, with interest rates already near zero, these efforts were insufficient to drive a robust recovery.
In November 2008, the Federal Reserve introduced its first round of Quantitative Easing, commonly referred to as QE1. This involved a significant change in the Fed's usual market operations, as it started buying substantial amounts of treasury bills, notes, bonds, and high-quality asset- and mortgage-backed securities. These purchases effectively injected more money into the US economy and reduced the cost of capital. The QE1 program continued from December 2008 to March 2010, along with another cut to the Fed Funds rate, resulting in an interest rate range of 0 to 0.25%.
VARIATION IN CENTRAL BANK ASSETS FROM MONETARY EXPANSION
With the Federal Funds rate hovering around zero and a reluctance to explore negative rates at that time, the central bank had effectively exhausted all its expansionary monetary policy tools. Therefore, quantitative easing became a crucial component of the central bank's arsenal to stimulate economic growth and stabilize the faltering US economy.
To bolster the recovery, the Fed embarked on subsequent rounds of Quantitative Easing, now referred to as QE2 from November 2010 to June 2011, and QE3 from September 2012 to December 2013. These purchase programs targeted similar assets and had the unintended consequence of buoying perceived growth and capital markets in the US.
These measures were sustained until the central bank finally shifted course by raising its benchmark rate for the first time in December 2015.
Furthermore, in 2018, the central bank had already commenced reducing its balance sheet, sparking debates over the idea of sustained Quantitative Tightening (reducing the balance sheet). Many Federal Reserve officials supported a gradual drawdown of the bank's balance sheet and advocated for further normalization, given the US economy's impressive expansion lasting over a decade. Nevertheless, uneven growth and external risks like trade wars have complicated the issue of providing continued exceptional support.
THE BANK OF JAPAN (BOJ) QUANTITATIVE EASING POLICY
Japan's central bank, the BOJ, has employed quantitative easing with varying success. In the late 1990s, they purchased trillions in Yen of commercial paper to aid banks during low growth, low interest rates, and bad bank loans, but growth remained subdued.
In response, the Bank of Japan increased asset purchases from 2001 to 2004, targeting long-term government bonds and injecting 35.5 trillion Yen in liquidity to banks. While moderately effective, the bond purchases suppressed asset yields, and during the Great Financial Crisis, Japan's growth vanished once again. Subsequent rounds of QE and QQE proved largely ineffective in combating low economic growth, despite a negative interest rate environment.
Presently, the Bank of Japan has diversified its asset acquisitions, encompassing a diverse array of holdings with differing levels of quality. In tandem with its existing procurement of commercial paper, the bank has amassed a substantial stake in Japan's exchange traded fund (ETF) market and Japanese real estate investment trusts or J-REITs.
The Bank of Japan (BOJ) initiated ETF acquisitions in 2010, accumulating approximately 70% of Japan's entire ETF market by the second quarter of 2018. Consequently, the central bank became the predominant stakeholder in over 40% of publicly listed Japanese companies, as reported by Bloomberg. Consequently, the inherent quality and credit rating of these holdings, as managed by the central bank, are significantly inferior compared to government-issued assets such as Japanese Government Bonds (JGBs). This distinctiveness sets them apart from the assets held by the Federal Reserve.
THE BANK OF ENGLAND (BOE) QUANTITATIVE EASING POLICY
Similar to the formerly stated central banks, the Bank of England (BOE) has accumulated substantial amounts of domestic government bonds (GILTs) and corporate bonds via its quantitative easing approach. This strategy was undertaken to fortify the UK's economy amid the peak of the worldwide recession, which would ultimately extend to the heightened peril of political uncertainties stemming from a Scottish Referendum vote, General Election, and eventually the Brexit. Concurrently, the bank has gradually elevated its overnight lending rate.
In contradistinction to its American and Japanese counterparts, the aggregate assets of the UK's central bank are notably diminished. When juxtaposed against the nation's GDP, the Bank of England's holdings constitute a mere 5.7% in the early months of 2019, pale in comparison to Japan's holdings that amount to over 100% of GDP. The comparatively limited holdings might enable the bank to act more efficaciously in the days to come, as the waning gains of quantitative easing have not yet taken effect.
At this moment, the effectiveness of the Bank of England's quantitative easing approach seems to surpass that of the Bank of Japan and align with that of the Federal Reserve. Given the ongoing uncertainties of Brexit, the institution might opt to uphold its safety net or potentially enhance its monetary policy measures. Nevertheless, the bank would maintain a notably lower dedication to quantitative easing compared to its neighbor, the European Central Bank.
THE EUROPEAN CENTRAL BANK (ECB) QUANTITATIVE EASING POLICY
The European Central Bank (ECB) adopted quantitative easing as an expansionary measure, albeit later than the Federal Reserve. During its most recent round of easing, the ECB spent nearly $3 trillion on purchasing government bonds, corporate debt, asset-backed securities, and covered bonds. These purchases occurred between March 2015 and December 2018 with the aim of preventing sub-zero inflation in the European bloc, which was still recovering from the global recession and the Eurozone Debt Crisis. Reuters reported that the purchases took place at a staggering pace of 1.3 million Euros per minute, equivalent to 7,600 Euros per person in the bloc.
Similar to Japan, the European Central Bank's easing measures demonstrated limited effectiveness. In the beginning of 2019, the ECB declared an additional round of easing by implementing targeted long-term refinancing operations (TLTROs). This decision came only a few months after concluding its open-ended quantitative easing (QE) program, while interest rates persisted at 0. TLTROs aimed to supply Eurozone banks with low-interest-rate funding to enhance bank liquidity and reduce sovereign debt yields. The loans offered maturities ranging from one to four years.
NEGATIVE EFFECTS OF QE: BALANCE SHEET USE AND DIMINISHING RETURNS
While quantitative easing (QE) yielded favorable results for the Federal Reserve and the United States, this monetary policy tool has proven less effective for the central banks of Japan and Europe and even led to some adverse consequences. The Japanese economy, after years of expansionary policy, now faces deflation, and the central bank's balance sheet has ballooned to exceed the country's GDP.
Moreover, the bank's significant ownership of the ETF, JRIET, and the government bond market may expose it to heightened risk if an economic downturn occurs. Despite numerous rounds of stimulus and negative interest rates, economic growth has remained elusive, and the Japanese central bank finds itself navigating uncharted waters in terms of monetary policy.
Likewise, the European Central Bank (ECB) has experienced a similar lack of influence from its version of quantitative easing, with inflation and growth remaining sluggish within the European bloc.
THE IMPACT OF QUANTITATIVE EASING ON CURRENCIES
Essentially, the implementation of quantitative easing leads to a surplus in the currency's availability. As per the fundamental principles of supply and demand, this surge should theoretically cause the currency's value to decrease. However, since currencies are traded in pairs, the weakened value of one currency is relative to its counterpart.
Given the current monetary policy landscape, characterized by abundant supply and dovish stances, only a few currencies demonstrate absolute strength. Nevertheless, strength has recently been attained through a 'best-of-the-rest' mindset, where a central bank's dovish shift is swiftly mirrored by others. These subtle competitive policies can escalate into more aggressive actions, resulting in what is termed a 'currency war'.
Thus, the worldwide money supply has swollen while the comparative worth of currencies stays uncertain. In the contemporary monetary policy environment, disparities in strategy have predominantly evolved into a contrast in accommodativeness. Amidst the significant central banks, only a few adopt a more stringent stance, and even fewer have intentions to hike their core interest rate. Instead, policymakers have turned to repeated injections of capital as quantitative easing seems to be garnering favor as a monetary policy instrument – though its permanence remains uncertain.
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