Quantitative Easing

This reading covers the roles and objectives of central banks, the tools of monetary policy and the transmission mechanism through which a policy-rate change reaches inflation. It then describes the qualities of an effective central bank, inflation, interest rate and exchange rate targeting, the neutral interest rate, the limits of monetary policy, and how monetary and fiscal policy interact.

LOS 15.a — What central banks do and what they aim for

Roles of a central bank. A modern central bank typically performs six roles:

Collecting taxes is not a central bank function; a separate government agency does it. Being banker to the government means providing it with banking services, such as holding its accounts; making loans to government agencies is not among the central bank roles listed here.

Inflation targets. Most developed-country central banks aim for inflation in a range around 2% to 3%. They avoid a zero target because random swings around zero would often mean deflation, which is disruptive. Exam convention: the US Federal Reserve and the Bank of Japan are the developed-country exceptions without an explicit inflation target. The Fed's goals also include maximum employment and moderate long-term rates, and Japan has struggled with persistent deflation. Current practice: both now have explicit 2% goals. The Fed adopted a longer-run goal of 2% inflation, measured by the PCE price index, in January 2012, alongside its dual mandate (maximum employment as well as stable prices). The Bank of Japan adopted a 2% CPI price stability target in January 2013 while fighting deflation.

Pegging. Some countries instead peg their currency to another currency, most often the US dollar, and run monetary policy to hold that exchange rate. How a peg is defended, and what it does to the money supply, interest rates and inflation, is covered under exchange rate targeting (LOS 15.c).

LOS 15.b — Policy tools and the monetary transmission mechanism

The three main tools

• In a repurchase agreement (repo), the central bank buys securities from a bank that agrees to buy them back later at a slightly higher price. The percentage difference between the two prices is the interest rate on what is, in effect, a short-term loan to the bank.
• Open market purchases: cash replaces securities in investors' accounts, banks get excess reserves, more funds are available for lending, the money supply rises and interest rates fall. Open market sales do the reverse and push rates up.
• In the US, the federal funds rate is the market rate banks charge each other for overnight loans of reserves. The Federal Reserve sets a target for it and uses open market operations (its most-used tool) to steer the actual rate there. Do not confuse it with the discount rate, which is the rate a bank pays when it borrows from the Federal Reserve.
• The central bank does not set exchange rates, the prices of government securities or the yield on existing bonds directly. It also cannot compel banks to tighten or loosen their credit standards. It can only encourage them.
• Lowering reserve requirements has an effect only when banks want to extend more loans and borrowers want to take them.
• Exam convention: the policy rate, reserve requirements and open market operations are the three working tools of monetary policy. Current practice: the Federal Reserve set its reserve requirement ratios to zero in March 2020, and with reserves plentiful since the 2008 financial crisis it steers the federal funds rate mainly through the interest rate it pays on banks' reserve balances rather than through day-to-day open market operations.

The monetary transmission mechanism is how a change in the policy rate reaches the price level and inflation. It works through four channels: other short-term rates, asset prices, expectations, and exchange rates. The figure traces a policy-rate increase:

1. Banks raise their short-term lending rates, so consumers cut credit purchases and firms cut investment.
2. Higher rates for discounting future cash flows lower bond, equity and other asset prices. The resulting wealth effect raises saving and lowers consumption.
3. Expectations of future growth weaken, so spending falls.
4. Higher rates attract foreign capital, the domestic currency appreciates, exports become more expensive for foreigners and net exports fall. Through this channel the trade balance worsens.

Together these reduce aggregate demand and push the price level down. The policy rate acts directly on the first links in the chain: other short-term rates, asset prices, expectations and the exchange rate. Inflation is the end point, reached through these channels and only after a lag. A policy-rate cut works through the same channels in the opposite direction.

Expansionary policy step by step. The central bank buys securities, so bank reserves rise and the interbank rate falls. Other short-term rates and then longer-term rates fall, and the currency depreciates. Business investment, consumer purchases of houses, autos and durable goods, and net exports all rise. Aggregate demand increases, which raises inflation, employment and real GDP in the short run. If money neutrality holds, monetary policy has no effect on real output in the long run.

LOS 15.c — Effective central banks, targeting regimes and limits of policy

Three essential qualities of an effective central bank

Relevance, reliability, comparability and consistency are financial-reporting qualities. They are not on the central bank list.

Independence comes in degrees rather than all-or-nothing. Even a fairly independent central bank may have its head appointed by politicians.

• Operational independence: the central bank alone sets the policy rate.
• Target independence: in addition, it defines how inflation is computed, chooses the target inflation level and sets the horizon for reaching it. The ECB has both types. Most other central banks have operational independence alone.

Targeting regimes

The most common inflation target is 2%, with a permitted deviation of ±1% (band 1% to 3%). Because of the deflation risk described under LOS 15.a, the band is set so that its lower edge (target minus deviation) stays at or above zero.

Exchange rate targeting mechanics. If the domestic currency falls below the target, the central bank buys domestic currency with foreign reserves. This reduces money supply growth and raises interest rates. If the currency rises above the target, the bank sells domestic currency, which increases the money supply and lowers rates. As a result, the money supply and interest rates can become more volatile. A country can run out of foreign reserves, so intervention has limits. Monetary policy must follow the peg regardless of domestic conditions, and the pegging country ends up with the anchor country's inflation rate.

Neutral interest rate and policy stance

Exam convention: the neutral interest rate is described as the growth rate of the money supply that neither speeds up nor slows economic growth. Current practice: it is treated as the policy interest rate at which policy neither stimulates nor restrains the economy, which is what the formula and the stance test below use:

• Policy rate above neutral: contractionary. Policy rate below neutral: expansionary. Equal: neutral.

Limitations of monetary policy

• Long-term rates may not follow short-term rates. The central bank controls short-term rates directly, but long-term rates, which drive most household and business decisions, reflect expected inflation. Tightening can lower long-term yields. If markets believe it will work, expected inflation falls. If they see it as too severe, the higher probability of a recession makes long-term bonds more attractive. Easing that markets see as inflationary can raise long-term yields. Investors who sell long-term bonds for this reason are called bond market vigilantes. With a credible central bank this effect is small.
• Liquidity trap. When the demand for money becomes very elastic, people simply hold the extra money as cash, so adding money does not push rates down or stimulate spending. Deflation that persists despite expansionary policy points to a liquidity trap.
• Zero lower bound. Exam convention: the nominal policy rate cannot be cut below zero, so a central bank whose rate is already at zero has little room left to stimulate. Current practice: some central banks (e.g., the ECB, the Swiss National Bank and the Bank of Japan) have set slightly negative policy rates, but not far below zero. Either way, deflation is harder to reverse than inflation. Inflation can be fought by raising rates, which have no upper limit.
• Banks may not lend even when excess reserves rise (as after 2008). With short-term rates near zero, central banks turned to quantitative easing (QE): large-scale purchases of longer-term government bonds, mortgage securities and even securities with credit risk. The aim was to lower long-term rates and create excess reserves that encourage lending. Buying securities with credit risk may also shift risk from the private to the public sector.
• Developing economies face extra problems: illiquid government debt markets (making interest rate signals unreliable and open market operations hard), difficulty estimating the neutral rate, rapid financial innovation that changes money demand, and central banks that lack credibility or independence.

LOS 15.d — Interaction of monetary and fiscal policy

When the two policies pull in opposite directions, the output entries follow the exam convention. Exam convention: expansionary fiscal with contractionary monetary policy is taken to raise aggregate demand and output. Contractionary fiscal with expansionary monetary policy has an output effect that varies, although the lower interest rates tend to raise private consumption and output. Current practice: in both mixed cases output rises only if the expansionary policy is the stronger of the two, so the direction depends on their relative strength. The sector-share effects (private vs. public share of GDP) and the direction of interest rates do not depend on that assumption.

• Contractionary fiscal + expansionary monetary: lower government borrowing and a larger money supply both lower rates, so the private sector grows and government spending as a share of GDP falls.
• Expansionary fiscal + contractionary monetary: rates rise (heavier government borrowing plus tight money), the public sector's share of GDP rises and the private sector is squeezed.
• Fiscal multipliers differ: direct government spending has had a larger multiplier than transfers or tax cuts. Among the latter, transfers to the poor have the greatest effect, followed by tax cuts for workers, then broad untargeted transfers. Every type of fiscal stimulus is more powerful when combined with expansionary monetary policy, possibly because of higher inflation, falling real interest rates and the extra business investment they bring. Cutting the discount rate or buying securities therefore reinforces expansionary fiscal policy during high unemployment.