WEEK 3 - Quantitative Easing (QE)

Question 1

What was the first instance response to the banking crisis?

Answer 1

Emergency liquidity provision used (Term Auction Facility (TAF) at the US fed)

Question 2

What was used to try and address solvency concerns to the banking crisis?

Answer 2

Capital Injections (RBS bail out)

Question 3

What were the long term solutions to the banking crisis (not considering QE)

Answer 3

Regulatory changes - To addressing shortcomings with bank capital requirements and undesirable bank practises to shock proof the sector

Question 4

What were some of the macroeconomic consequences of the crisis?

Answer 4

-Largest GDP reversals since the Great Depression: (UK real GDP at the start of 2010 more than 6% less than at the end of 2008)

• particularly weak
  recoveries from the depths of the recession
• Personal incomes were forecast by some economists as being unlikely
  to return to their pre-recession levels until the middle of the 2010s.

Question 5

What was the policy environment in response to the banking crisis?

Answer 5

• Dramatic interest rate cuts: in November 2008 the Bank of England
  reduced its policy rate by 150 basis points (typical policy changes 25 points)
• 2009 central bank interest rates at 0.5% in the UK, 0-0.25% in
  the US and 1% in the Euro area.
• Fiscal deficits and sovereign debts have rose sharply as the world
  economy slowed and automatic stabilisers operated to cushion
  demand.
• Central banks resorted to QE

Question 6

What are some unconventional policies implemented by countries during this time?

Answer 6

BOE - Asset Purchase Facility (APF): Via portfolio rebalancing, asset prices and exchange rate (Govt bonds etc.)

Fed - Large Scale Asset Purchases (LSAPs): Via flattening yield curve
(US govt and securities issued or guarnteed by GSE’s)

-Quantitative Easing

Question 7

Why are nominal interest rates not negative?

Answer 7

Because negative interest
rates constitute a tax on depositors/investors and can be avoided
through hoarding cash

Question 8

What is the zero lower bound (ZLB) for nominal interest rates?

Answer 8

limits the `extent to which conventional monetary policy can be used to
stimulate demand in recessions.

Question 9

Why is there a Zero lower bound?

Answer 9

Once rates at 0, govt can no longer reduce rates any further to stimulate demand

Question 10

How does QE work?

Answer 10

Central bank creates electronic accounts credited with new cash balance (addition to the monetary base), and uses these accounts to purchase assets from financial institutions.

This has the effect of increasing private sector (e.g. commercial bank)
cash balances - Which then go out to loans and increasing circular flow of income

Question 11

When was QE first mentioned in a policy meeting?

Answer 11

QE first used by Japan in the early 2000’s

• First mentioned during a policy and recommended as policy action by BoJ member Nobuyuki Nakahara

Question 12

What is unconventional about QE?

Answer 12

Asset purchases financed from newly created cash, so overall balance sheet of central bank increases.

Despite purchasing asset being regular open market operations

Question 13

How does conventional OMO’s (open market operations) operate?

Answer 13

Involve central banks financing asset purchases
through reducing their holdings of some other asset (medium-term
bills, foreign exchange etc.)

i.e composition of central bank assets shift towards less liquid end of spectrum but total assets unchanged

Question 14

How is QE risky and how has the govt covered this risk?

Answer 14

• Risky as it entails balance sheet expansion

- To cover this treasury to underwrite and parliamentary approval required

Question 15

Why does the implementation of QE rely upon treasury approval?

Answer 15

The Treasury indemnifies the Bank against losses arising fromthe Asset Purchasing Facility and thus exposes the taxpayer to risk.
The consequence is that the use of the QE instrument is effectively at
the discretion of government and this undermines the operational
independence given to the Bank in 1997

Question 16

How is QE implemented in practise?

Answer 16

• Buy up govt bonds from pension fund (as example) using their bank as intermediary (1st row)
• Finances these purchases via crediting reserves to pension fund’s bank (gives em an IOU) (2nd row)
• Commercial bank’s balance sheet expands: New deposit liabilities matched with an asset in form of new reserves (3rd Row)

SEE GRAPH

Question 17

Why is it better to provide electronic money to the bank rather than the pension fund?

Answer 17

If the bonds are held by a non-bank (e.g. pension fund), then the exchange results in an increase in central bank reserves held
by banks and an increase in the amount of bank deposits held by the private sector.

If bonds sold to banks, quantity of deposits held by public not change bank merely swaps bonds for central bank reserves

Question 18

What are some distinctive features of QE?

Answer 18

• Assets purchases operate to a quantitative target (£375bn), where conventional OMO’s operate to price target e.g buy bonds til money supply enough to lower interest rate to a lvl
• QE used whilst interest rates at the ZLB, so monetary policy cannot
  be set as a price target
  Since it is specified in quantity terms, there is a re-investment decision when assets mature.

Question 19

What was the intended impact of QE?

Answer 19

• To increase spending by encouraging more private sector borrowing
• Intended to increase wealth of asset owners (wealth effect) encouraging to spend more

Question 20

According to Benford et al. what is the aim of QE?

Answer 20

The aim of quantitative easing is to inject money into the economy in order to revive nominal spending, by increasing asset prices and decreasing (long-term)
interest rates.

Question 21

How does portfolio re-balancing work?

Answer 21

• QE leaves private investors long in cash that yields low return to generate returns re-balance portfolios towards assets such as corp bonds and equity issued by firms
• These private assets cetnral elements of shadow banking system

Question 22

What is the shadow banking system?

Answer 22

the means by which large firms obtain finance without

using banks

Question 23

What is the key point behind the interest rate of corporate bonds?

Answer 23

These interest rates are positive even when the
policy interest rate of the central bank is at or close to zero (e.g. due to the risk on lending to these firms versus depositing cash at the central bank)

Question 24

What is the benefit of portfolio rebalancing from QE? (Part 1)

Answer 24

Drives up prices for corporate bonds and equities, depressing the interest rates paid in the shadow banking sector

Question 25

What is the benefit of portfolio rebalancing from QE? (Part 2)

Answer 25

Facing lower financing costs in the shadow banking sector, corporations are better able to engage in hiring, investment etc.,
which boosts aggregate demand.

Question 26

What are the caveats behind the lower financing costs?

Answer 26

1. corporations may use lower financing costs to boost profitability and
   their capital ratios, so rises in expenditure may be delayed

2.small firms and households will not benefit directly, only indirectly if large corporations choose to spend the gains from cheaper finance.

Question 27

How can we influence expectations?

Answer 27

• Interest rates
• When borrowing money over 10 yrs what matters is:
  1. Avg interest rate over 10 yrs
  2. Avg inflation rate over 10 yrs
• Consumption and investment most likely to rise if interest rates expected to stay at low lvls
  for extended period and inflation likely to be high for extended period

Question 28

How is the credibility of the policy maker important in influencing expectations?

Answer 28

• optimal central bank policy to promise to deliver low interest and high inflation over extended period
• Promise not time consistent: If bank cares about inflation, when future growth and infl start to rise in response to low interest rates, policymakers seek to return SR interest to normal lvls to avoid missing infl target
• Private sector may not respond to any promises to keep interest rate low as result of above point

Question 29

Has QE worked?

Answer 29

Impossible to say because we do not know what would have happened in the absence of QE (known as the counter-factual)

Question 30

What are the positives of QE?

Answer 30

1. Shadow banking system has boomed - UK stock market rose 22% in 2009
2. Currencies such as the US$ and sterling have been weak and government bond yields have remained low despite the acceleration of
   government debt
3. Bernanke noted inflation and infl expectations risen close to 2% since 2010 deflation

Question 31

What are the negatives of QE?

Answer 31

1. Bank lending to consumers and small firms remained weak e.g Neg net mortgage lending in UK many month since 09
   (consumer spending stayed low)
2. Bank of Japan launched QE a decade ago but economic performance
   remains disappointing
3. Although large corporations have benefited from a low cost of capital,
   there is evidence the savings are being used to retire more expensive
   debt and build corporate cash reserves reducing the prospect of an invest-led recovery.

Question 32

What are the risks associated with QE?

Answer 32

• No sign QE currently feeding inflation

- Risk of hoarding by MFI’s(Micro Finance Institution)