SERIOUS MONEY:THE ONSET of the financial crisis three years ago unleashed significant deflationary pressures upon the US economy; the resulting surge in liquidity preference depressed aggregate demand and a sizable output gap opened as economic activity fell well short of potential. Aggressive monetary and fiscal stimulus prevented a repeat of the Great Depression, but a self-sustaining recovery has proved elusive – the real demand for money remains high and, as a result, the uptick in economic activity from last summer's trough has failed to reduce the output gap.
Near-zero policy rates remain above the natural rate of interest or the real rate consistent with price stability and, constrained by the lower bound for interest rates, the Federal Reserve has little option but to engage in a further round of quantitative easing in an attempt to awaken the economy from its slumber and combat deflationary pressures.
Ben Bernanke, the Fed chairman, hopes that future asset purchases will lower treasury bond yields and induce the private sector to reinvest the proceeds of security sales in higher-yielding risk assets. Should such portfolio rebalancing occur, it could result in higher prices for risk assets and precipitate greater investment spending via a lower cost of funds, and increased consumption via a wealth effect. Hope is not a strategy, however, and the effectiveness of quantitative easing as a policy tool is far from conclusive.
Gauti Eggertsson and Michael Woodford argue that asset purchases by a central bank would prove largely ineffective if they fail to alter expectations regarding the future path of policy. Economic activity can only be influenced by changes in expectations of future real rates, which means that quantitative easing alone will not increase aggregate demand. Consequently, the policy regime must be accompanied by a commitment that accommodative monetary policy will remain in place until certain conditions have been satisfied even if normal policy rules call for higher interest rates.
The Bank of Japan, for example, began its quantitative easing policy in 2001 and announced that the new regime would remain in place “until the core CPI registers stably zero per cent or an increase year on year”. The strength of the commitment served to change the expected path of future short-term interest rates, which resulted in as much as a half percentage point decline in three-five-year yields. The commitment to keep forward interest rates near zero until the inflation rate turned positive proved to be the most effective transmission mechanism for the Bank of Japan’s quantitative easing policy regime from 2001 to 2006.
The Federal Reserve has announced on several occasions “interest rates are likely to remain low for an extended period”. However, unlike the commitment pledged by the Bank of Japan, there is no definitive link between accommodative monetary policy and the inflation rate. This means that investors have no clear-cut policy target upon which to anchor the likely path of forward rates. Thus, the transmission mechanism that was most potent in Japan is absent from Fed policy.
In the absence of a commitment effect, the US monetary policy must that believe portfolio rebalancing will be sufficient to thwart deflation. The central bank’s purchase of treasury bonds with newly created bank reserves, which are equivalent to treasury bills at near-zero interest rates, lowers the interest rate volatility of the banking system’s investment portfolio. The reduction in portfolio risk should see banks rebalance their portfolios and use part of their excess reserves to accumulate risk assets, especially if risk premiums are sufficiently attractive vis-a-vis cash.
Portfolio rebalancing is fine in theory but is unlikely to prove effective in practice unless the private sector can be induced to increase its allocation to risk assets. If the banking system’s level of risk aversion does not fall, then the proceeds of asset sales are likely to be held as excess reserve balances at the Fed if the securities purchased by the central bank and the reserves credited to the banking system are considered close substitutes. If they are not close substitutes, then part or all of the proceeds may be used to purchase such securities including longer-duration treasury bonds and investment-grade corporate debt. In either case, the impact of quantitative easing would prove minimal.
The Japanese experience from 2001 to 2006 corroborates these observations. Although the commitment effect proved to be material, the impact of the quantitative easing programme on asset prices was largely absent. Stock prices did not benefit at all and any reduction in the spreads on corporate debt was confined to those firms with the highest ratings.
Investors have gravitated towards risk assets in recent weeks as the Fed’s “open-mouth” policy revealed that a further round of quantitative easing was on the way. Expectation became reality on Wednesday, but the latest instalment in the battle against deflation may not prove as effective as the bulls suggest. The policy lacks a credible commitment mechanism and the desired portfolio rebalancing may well prove elusive.
The latest round of quantitative easing is nothing more than a shot in the dark by a desperate central bank and investors should use the opportunity to reduce risk allocations.
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