NRPLUS MEMBER ARTICLE T he Fed announced its fourth round of quantitative easing (QE) on Sunday. In addition to cutting the benchmark interest rate to zero, the Fed will purchase $700 billion worth of Treasuries and mortgage-backed securities with two aims: 1) boosting liquidity in the financial system; 2) increasing aggregate demand by expanding the money supply.
Central banks have intermittently purchased assets from financial institutions since roughly 1990, when the Swedish and Finnish central banks undertook quantitative easing in response to the Nordic banking crisis. In 2000, the Bank of Japan was the first major-economy central bank to conduct asset purchases. The Federal Reserve and Bank of England followed suit after the 2008 financial crisis.
Under Chairman Ben Bernanke, the Fed initiated its first round of QE (“QE1”) in December of 2008 and followed up with two subsequent rounds until suspending asset purchases in December 2014.
Zero Lower Bound
Traditionally, central banks have conducted monetary policy by setting the policy interest rate. In the U.S., that’s called the federal funds rate. By decreasing rates, the Fed spurs borrowing, which increases the money supply. With more money in the economy, consumers will theoretically spend more, and businesses can invest at a lower cost. Conversely, the Fed increases rates in order to reduce the risk of inflation when the money supply grows too large.
But when the policy rate hits the “zero lower bound,” the Fed can’t stimulate the economy through conventional means. That’s what happened in 2008, when the Fed cut the federal funds rate to zero during the deepest recession since the Great Depression, and it’s happening again.
The Role of Unconventional Tools
When a central bank hits the zero lower bound, it has to turn to unconventional monetary tools or risk letting the economy fall into an uncontrolled recession. Unconventional tools include QE, as well as forward guidance (forecasting future interest-rate changes), negative interest rates (charging banks to hold reserves at the central bank), and “helicopter money” (transferring money directly to consumers). Alternatively, academics and practitioners have advocated broader structural changes to the monetary regime — such as increasing the inflation target or targeting a different metric (e.g., nominal income) — to combat the zero-lower-bound conundrum. While the Fed has limited its unconventional tools to QE and forward guidance, the European Central Bank has instituted negative interest rates as well.
By purchasing assets from banks, the Fed increases banks’ holdings in cash as opposed to financial securities. That expands the total currency in circulation and the availability of credit, which increases aggregate demand. Before 2008, the monetary base (the sum of currency in circulation and deposits held at the central bank) expanded at a relatively stable, constant rate. But QE increased the monetary base at an unprecedented rate.
Actual Inflation/Inflation Expectations
Partially as a result of QE, inflation expectations remained above 2 percent throughout the crisis, despite a precipitous fall in actual inflation. If consumers expect low inflation (or worse, deflation), they will increase savings relative to consumption. Low inflation expectations can spur a self-fulfilling prophecy in which the belief that prices will fall curbs consumer spending, thereby causing a drop in prices and exacerbating a recession. So asset purchases not only increase the money supply today, they increase consumers’ willingness to spend by elevating inflation expectations. All of this amounts to a jolt for the economy, but it comes with costs.
Proponents believe that the stimulus transmitted through asset purchases contributed to the recovery of the U.S. economy after 2008, but critics argue that it could lead to hyperinflation. That has yet to materialize; in fact, inflation has often been below the Fed’s 2 percent target over the past few years. But research suggests that the efficacy of asset purchases depends on a central bank’s credible commitment to unwind its balance sheet afterward. Since ending QE in 2014, the Fed has sold only a small portion of its assets. It remains to be seen whether a further expansion of the balance sheet will have an inflationary effect.
Others say that asset purchases effectively subsidize banks while consumers continue to struggle. On one hand, it is true that banks benefit from asset purchases, as they get access to much-needed cash at times of stress. On the other hand, the financial system is the most effective way to channel credit to consumers. Indeed, mortgage-backed-security purchases directly decrease borrowing costs for households.
What’s certain is that we are in the midst of a massive economic experiment. After a decade of near-zero interest rates, the Fed enters this recession with no conventional tools at its disposal. Couple that with massive government debt and deficits, and federal efforts to combat the crisis will need to be nothing short of inspired.