Quantitative Easing

With the current world economy in a severe recession and many looking for answers about economic rejuvenation, the United States is embarking on an experimental monetary policy called quantitative easing, which the Japanese attempted (and at which they miserably failed). The principles of quantitative easing have a tinge of 1930s Keynesian monetary policy, with a focus on government intervention to control policy from the demand side with stimulus and laissez-faire economic principles. This will allow markets to control short-term rates.

However the economic cards play themselves out is irrelevant to the fact that the US is traveling down an unfamiliar road. If this experiment succeeds, traders will be able to play the long side of any market and reap huge rewards. Conversely, if this effort fails, the short side will be where traders can generate giant profits. For now, expect markets to trade large ranges until a clearer picture develops.

QUANTITATIVE EASING IN JAPAN
I would like to highlight this policy of quantitative easing as first practiced by the Japanese and then relate the Japanese differences to quantitative easing as it applies to current US monetary policy. Because the United States is the world's leading economy, other nations are watching the effects of quantitative easing to determine if they can adopt this same policy to pull their own economies out of 1930s-style recessions.

At its core, quantitative easing has three policy prescriptions: a zero interest rate policy, expansion of all banks' current account balance sheets, and the purchase of long-term bonds. At face value, this monetary policy sounded like a winner. The idea was to protect the banks from total collapse. The Japanese lowered their prime rate to zero and adopted what is known as ZIRP (zero interest rate policy). But this interest rate decline eased as the monetary base expanded.

Next, the Japanese expanded their banks' balance sheets by increasing their monetary base. The problem here was twofold. Because of ZIRP, an expansion of their monetary base couldn't tie into their short-term call rates. (Call rates are equivalent to our Fed funds rate and Great Britain's Libor.) So the Japanese targeted their banks' reserve requirements instead of allowing short-term rates to dictate their market policy.

Second, the Japanese went beyond their initial target of reserve requirements so their banks had plenty of money to lend, but economic situations didn't warrant a loan to be made. The Japanese actually went 70% above their reserve requirement target. They were unable to increase their multiplier effect of money that allows loans to be productive. As a result, money remained stagnant.

The only way for the Japanese to increase their monetary base was to purchase long-term government bonds. Quantitative easing for the Japanese lasted as governmental policy from 2001 to 2006. During this period, they purchased roughly over 1.2 trillion yen of long-term bonds. What was the purpose of these purchases when their interest rates were at zero? How much yield were they earning?

The hope for quantitative easing was to stimulate demand throughout the economy, a Keynesian approach. By doing so, inflation and the consumer price index had to increase. And therefore, their economy had to reinflate itself.

The initial target for the Japanese and a measure of success had to be a rise in their version of the consumer price index (CPI) as a measure of rising prices. So when the index bottomed, the Japanese believed they would find success in quantitative easing and the economy would turn around. The index was the target but it was never met, because it had yet to bottom in the year 2009.

Of the many troubled banks in Japan throughout the quantitative easing period, 19 were downgraded with lower credit ratings. Yet credit extensions were still at a minimum, and no banks were lending. So did quantitative easing rescue these banks and prevent outright defaults? We may never know.

What effect would increasing the money supply have on prices and output? And could an economy improve under these conditions? The Keynesian economic theory of the 1930s says that as money supply increases, short-term rates must come down to have any stimulation. Once those interest rates reach zero, output and prices won't have any more effect. This is what economist John Maynard Keynes termed the liquidity trap.

For the Japanese with their cheap currency, some consumer spending and investment were actually realized, and that is what stopped the deflation spiral. The dilemma here was much of their growth was realized from exports, while the overall economy failed to realize any long-term economic gains.
Ironically, the Japanese economy is an export-driven economy. While the price of their currency dropped long and hard over this quantitative easing period, this only meant they had to export more in order to realize any profits.

Since 2006, the Japanese have abandoned their experiment with quantitative easing and adopted instead the focus on prices and inflation targets. Due to the present world economic crisis, however, the Japanese will still find themselves in a deflationary situation with not much relief in sight.

AND IN THE UNITED STATES
For the United States, according to the last Fed statement, the focus is on economic growth and price stability with a Fed balance sheet sustained at a high level. What does this portend for the US and how does this relate to the Japanese experiment?

Short-term rates are currently near zero, and all indications predict the same for the near future while their monetary base has increased from $850 billion in August 2008 to $1.7 trillion on December 31, 2008. All indications predict an increase in their monetary base through the Troubled Assets Relief Program (TARP) and their Term Lending Facilities, not to mention the additional spending by the government through their stimulus package. The Fed supplies liquidity to the private sector by granting loans of Treasury securities against less liquid capital. This is a swap where the Fed holds the short end until the borrower pays back the loan. This is the Term Lending Facility. The TARP is the lending of money to the private sector in exchange for a special class of stock or preferred stock.

Much speculation abounds about the allowance to pay interest on reserve requirements at the target rate so the rate would never fall below zero or even below its intended target. This is to provide stability while we are enduring this crisis. US law doesn't allow this at present, but the Financial Services Regulatory Relief Act of 2006 gives the Federal Reserve this right as of 2011; that aspect of the act was granted in November 2008. In this act, Congress speeded up the approval process to allow interest to be paid on reserve requirements so the Fed funds rate does not trade below zero. All three policies have the intended effect of dramatically increasing the monetary base to exorbitant levels. Just like the Japanese, however, US banks are still not lending. With the zero interest rate at or near a zero interest rate policy, banks still have a problem borrowing short and lending long.

So the Fed's answer is to increase its alphabet programs of lending to the private sector to provide the liquidity that banks cannot or will not provide. For example, the Term Securities Lending Facility is a 28-day lending facility that offers to the Treasury general collateral to the Federal Reserve Bank of New York's primary dealers in exchange for other program-eligible collateral.

As of February 9, the Fed offered $150 billion in 28-day credit through its Term Auction Facility. This is the mechanism that keeps the markets functioning on a daily basis and prevents outright collapse. The Term Asset Backed Securities Loan Facility began November 24, 2008, under 13(3) of the Federal Reserve Act and offers asset-backed securities as a way to boost consumer and small business loans. To facilitate car loans, student loans, credit card advances, and small business loans, $200 billion will be offered.

IS IT SUCCESSFUL?

The Japanese gave their primary focus of quantitative easing to targeting their banks' balance sheets without supporting other aspects of their economy, while the Fed has given its focus first to the markets, then to major companies, and finally to consumers. Yet the original conundrum that caused this ripple effect was the collapse of the housing market, which has not been totally addressed.

Many banks were caught with bad housing loans when the market collapsed, and those loans are still on their books listed as assets, but assets that are no longer performing because homeowners have since defaulted. Here lies the problem, and the question: Should their representative governments also adopt this policy of quantitative easing? Great Britain, Canada, Australia, New Zealand, and the Swiss are all heading down the path, while the Europeans in general are still studying the issue. Many question its success due not only to the Japanese experiment, but the exorbitant increase in the monetary base as well as huge government deficits soon to follow.

Since short-term rates are market-driven, why not use monetary policy through open market operations to alleviate this credit dilemma? Doing this could forestall the need to lower interest rates to zero, obviate the need to increase the monetary base, and eliminate the need to increase the budget deficit through stimulus packages. An open market operation is the avenue for the Fed to buy or sell government securities as a way to add or subtract liquidity to the markets and the economy. Other arguments include using the Taylor rule, which states that the Fed should order high interest rates when inflation is above its target or when the economy is above full employment.

How should a central bank set short-term rates as economic conditions change to achieve its short-term goal for stabilizing the economy? While the Taylor rule may not necessarily be apt in this example, it still serves as an important tool that has been used by policymakers over many years.

The jury is still out on the quantitative easing experiment. We don't know if it works. Will it prolong our recession? We don't know that either. In the end, will we become Keynesians again, or stay with our supply-side ways? It's too early to tell about that, too. Traders of all markets should pay particular attention to additional policy developments in anticipation of either booming markets ahead or plummeting markets.

SUGGESTED READING
Carlson, John, and Sara Wakefield. "A Focus On Quantitative Easing," Cleveland Federal Reserve.

Eggertsson, Gauti, and Michael Woodford. "The Zero Bound On Interest Rates And Optimal Monetary Policy," New York Federal Reserve.

Goodfriend, Marvin. "Interest On Reserves And Monetary Policy, New York Federal Reserve."

Keister, Todd; Antoine Martin, and James McAndrews. "Divorcing Money From Monetary Policy," Cleveland Federal Reserve.

Spiegal, Mark. "Did Quantitative Easing By The Bank Of Japan Work?" Federal Reserve Bank of San Francisco.

"What Is The Taylor Rule? And What Does It Say About Federal Reserve Monetary Policy?" Federal Reserve Bank of San Francisco.