Quantifying QE: New Measures Can’t Work Long-Term

All examples in this presentation are hypothetical interpretations of situations and are used for explanation purposes only.  The opinions expressed in this report are those of the author and do not necessarily represent those of the CME Group or affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience. 

Since the 2008 financial panic, central banks in the US, UK, Europe, and Japan have experimented with the aggressive use of their balance sheets to stabilize their financial markets and encourage a return to higher rates of economic activity.  These activities have become known as quantitative easing or QE.  This report focuses mostly on balance sheet activities employed by the US Federal Reserve (Fed), and distinguishes between the initial round of quantitative easing (QE1) in late 2008 and 2009, with later rounds of balance sheet activity to purchase more US Treasury securities (QE2) and to adopt the maturity extension program (i.e., Operation Twist).  With respect to certain of the ideas presented here, in a few cases we also consider European Central Bank (ECB) activities where relevant to the discussion. 

Our first priority is to present a generalized set of theoretical ideas to guide our assessment of quantitative easing and to identify the conditions under which it is likely to achieve the desired economic and financial market results.  We recognize that some of these ideas may be controversial.  We believe there is considerable value, however, in explicitly recognizing the embedded assumptions in models designed to assess the impacts of quantitative easing.  By making key assumptions explicit, we can better understand why different quantitative models see quantitative easing in such varying light, and we can better interpret their likely robustness as a tool to guide either policy decisions or market participant actions.  Finally, as we link our theoretical ideas with the actual quantitative easing that has occurred, we want to draw some tentative conclusions about when it is most appropriate to use QE and, in addition, to evaluate whether future QE policies are likely to achieve their objectives. 

To highlight our conclusions, our research suggests the following: 

  • Quantitative easing is a very effective tool for central banks to use when combatting a failing banking system facing systematic solvency and liquidity challenges. 
  • Moreover, central bank purchases of securities held by a weakened or failing banking system may be more effective in encouraging a more rapid return to economic growth than other forms of QE such as outright loans to the banking system. 
  • In the context of a relatively sound, profitable, and well capitalized banking system, quantitative easing may have little to no positive impact on economic activity or labor markets despite its impact on interest rates.  Indeed, using QE when the likely effects are centered on rates and not on economic activity has the distinct potential to be counterproductive in terms of achieving the objectives of the central bank due to the fact that the use of QE sends a powerful signal from the central bank of economic pessimism to market participants. 
  • Quantitative easing in the form of purchases of securities with long-term maturities can have a meaningful effect in terms of lowering long-term interest rates.  The opposite effect on rates will occur, however, if and when central banks unwind their expanded portfolios and return to normal monetary policies. 
  • Exit strategies from QE by central banks may be extremely challenging to implement and have the potential, if not the certainty, to delay a return to the normal conduct of monetary policy to the detriment of longer-term economic growth, currency values, and potential future inflation.  That is, the long-term costs to economic activity and financial market stability of QE have the potential to be quite large. 

Quantitative Easing and the Case of a Failing Banking System 

Whether they explicitly recognize the embedded assumption or not, virtually all equilibrium models of economic activity and market behavior start from the presumption that money is fungible, and that the domestic money and credit markets, generally characterized as the banking system, are functioning normally.  What we mean by functioning normally is that banks are willing to pay and receive payments from each other and to make and take short-term loans from each other on essentially a no-name basis. 

The financial panic of 2008, triggered by the bankruptcy of Lehman Brothers and the next day’s relatively messy bailout of AIG, so scared bankers that they were, in many cases, afraid to take each other’s credit risk, even overnight.  The interbank market nearly froze, and spreads for interbank loans rose dramatically relative to similar maturity Treasury bills.  That is, the sharp widening of the TED spread (i.e., LIBOR minus Treasury bill rates) was a reflection of a failing banking system. 

As thoroughly examined by Reinhart and Rogoff (2009), recessions triggered by a financial crisis are fundamentally different from cyclical recessions that do not involve a breakdown of the banking system.  Recessions related to banking system breakdowns are characterized by a sharp drop in asset values which puts bank solvency into question and leads to extensive deleveraging by consumers, corporations, and local governments.  Consumers seek to reduce their liabilities to better match the lower value of their assets.  Corporations seek to rapidly shed costs, including workers, to better match future production with the likely lower demand.  Local governments face a sharp drop in tax and fee revenue and also seek to cut costs by reducing services, laying-off workers, and avoiding new projects that would require additional debt issuance. 

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