Tuesday, March 17, 2009

Debate on quantitative easing

An interesting debate is on about the utility of monetary policy during recessions, especially when interest rates are touching the zero-bound.

It has long been argued in the neo-Wicksellian paradigm that as part of stimulative monetary policy, Central Banks should lower their very short term interest rates, thereby reducing both bond yields and longer term rates, and boosting aggregate demand, future growth and inflation. But when short term interest rates are zero, expectations of future inflation and growth are not well-anchored, and central banks consider operating on longer term rates, this paradigm looks incomplete. In such circumstances, it would appear that monetary loosening by Central Banks should aim at increasing bond yields, since it would signal higher expected growth in real output and attendant inflation, which would in turn increase long term interest rates.

It is in this context that Nick Rowe points to a question raised by David Altig of the Atlanta Fed in Novemeber 2008,

So, if stimulative monetary policy is what we are after, should we be looking for lower long-term rates or higher long-term rates?

With the interest rates touching the zero-bound, rendering conventional interest rate driven monetary policy responses to the banking crisis superfluous, Central Banks across the world (and here) have been toying with unconventional responses like buying private sector assets by issuing Treasury Bills and "quantitative easing" (QE) techniques. Under QE, the Central Bank will buy government securities and private assets like commpercial paper (CP), using its own money, either newly printed or from available stocks, thereby effectively adding to the monetary base.

By resorting to QE, specifically by purchasing long term government securities, the Central Bank is hoping that its purchases would push up the bond prices, and hence lower bond yields, and lower longer term interest rates. It is then hoped that this would set in motion a cycle of expectations about future economic prospects that would boost investment, increase real output, boost consumption, increase inflationary expectations and hence lead to higher interest rates.

In other words, the success or otherwise of QE would depend on the relative effects of the purchase of securities and the impact on expectations about the future growth prospects. The need of the hour being expectations of higher growth and resultant future inflation, which would force up interest rates, it is important that QE too achieve the same result. This can be achieved only if the effect of expectations about future growth exceeds and dominates the effect of purchase of securities.

In normal times, nominal short term interest rates can be effective in driving long term expectations. However, when interest rates are touching the zero-bound, Nick Rowe argues that "a permanent increase in the money supply (or one that is expected to be permanent) will have a different, and bigger, effect today than a temporary increase in the money supply (or one that is expected to be temporary)".

About its transmission down the economy, Rowe writes, "The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don't want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don't want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money."

Paul Krugman though disagrees and feels that once short-term interest rate become zero, "money becomes a perfect substitute for short-term debt", and "any further increase in the money supply therefore displaces an equal amount of debt". He feels that QE techniques like buying long-term debt or risky assets, will have an effect not by increasing money supply, but by the central bank taking some risk off the private sector’s hands, with all its attendant consequences.

Update 1
William Buiter makes the distinction between QE (expanding the monetary base), credit easing (outright purchases of private securities by central banks), and enhanced credit support (provide collateralised loans on demand at maturities up to a year at the official policy rate). He argues that all these measures worl when the credit markets face liquidity crisis, but not when the problem is a solvency crisis.

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