By John Richards
As the recession deepens, policy rates around the world are rapidly approaching zero and they cannot go any lower. Does that mean that central bankers have run out of ammunition? Not necessarily.
With policy rates approaching zero, central banks can still impact the economy by buying government securities across the yield curve, bringing down longer term interest rates, thereby boosting the economy.
The US Federal Reserve adopted this strategy at Tuesday's federal open market committee meeting. Now, the asset (securities) and the liability sides (deposits) of the Fed's balance sheets will expand rapidly.
Support will be provided indirectly to leading sectors of the economy, such as housing, as the Fed purchases mortgage-backed securities and the debt of government sponsored enterprises such as Fannie Mae and Freddie Mac.
Because the Fed's balance sheet is set to expand almost without limit and without regard to the level of the policy rate, this policy is called quantitative easing.
But does quantitative easing work? Does it have unforeseen consequences? Japan is the only economy in recent times to have tried a full-scale version of quantitative easing for a significant period.
The Bank of Japan lowered the policy rate to zero in February 2001 and then went to quantitative easing the next month. It ended both quantitative easing and its zero interest rate policy only in 2006.
In Japan's case, the mechanics were simple. The BoJ added reserves to the banking system through open market operations and by directly purchasing government securities from the secondary market.
The size of the bond-buying operation (Rinban) became the policy tool to target the level of reserves rather than the policy rate, which was fixed at virtually zero.
The BoJ's monetary policy committee voted on the desirable level of reserves and the size of the Rinban, much as it had previously voted on the level of the policy rate.
And, when the economy deteriorated further, the BoJ increased the Rinban, pumping up reserves. At its peak, reserves reached around Y35,000bn of which only around Y8,000bn were required.
It is a matter of debate whether or not quantitative easing had much impact on the Japanese economy, even though it coincided with the longest expansion in Japan's post world war two history (2002-2007). But, I think not.
Quantitative easing was nearly irrelevant to the expansion of real economic activity that began in 2002. The expansion was largely self-financed by corporations' free cash flow and therefore not constrained by an absence of banks' lending.
Neither were there big liquidity problems in Japan to be solved by quantitative easing. Capital injections and guarantees to the banks had largely cured them well before the process began.
Money market rates were already low and their spreads were tight to the policy rate. High oil and other input prices ended headline consumer price index deflation, but the CPI less food and energy continue to be nearly flat even now.
This makes it hard to argue that quantitative easing ended deflation; high oil prices did that. Meanwhile, the economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment.
However, the bond market during quantitative easing was anything but smooth. The process ignited a bond bubble, whose eventual collapse destabilised financial markets, even threatening Japan's hard-earned economic recovery. Long- term interest rates began to plummet in the spring 2002, with 10s reaching 0.48 per cent in June 2003, down 120 basis points over the year.
The yield curve experienced a rolling flattening in which successively longer maturities tightened down on the zero policy rate.
When the bond-bubble burst in June 2003, rates soared and the curve steepened sharply. This created what in Japan is still known as the Var-shock because of the sudden rise in yields and the accompanying jump in volatility triggered when banks, which were using similar risk management models, tried to dump Japanese government bonds at the same time.
The effects on banks' earnings were so severe that it raised concerns that the economy would be plunged back into another 1990s-style period of economic stagnation.
About all quantitative easing did on the positive side for Japan was to help the BoJ keep its independence from the politicians by giving the appearance of action.
The costs were the shutting down of the money market, although it revived fairly quickly when QE ended, and a dangerous bond-bubble, whose popping threatened the recovery and destabilised the financial system.
One of the lessons of this episode for policymakers is that while quantitative easing may help to solve the short-run liquidity problems that arise in times of extreme financial duress, it is not a substitute for some of the harder choices governments must make.
These include underwriting of systemic financial risks, e.g. by guaranteeing bank deposits, the re-capitalisation (forced or voluntary) of the banks, regulatory pressure on banks to disclose and write down the bad assets, or the pressures on businesses directly via their banks to restructure and deleverage or shut down.
A worst-case current scenario is that policymakers rushing to quantitative easing fail to understand this, giving us a bond-bubble but no permanent fixes of the underlying structural problems.
In that case, when the bond-bubble bursts, paradoxically, quantitative easing will have increased systemic financial risks instead of decreasing them.
John Richards is head of Research, Royal Bank of Scotland, Asia Pacific
