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Julian D. A. Wiseman
Abstract: Quantitative easing, or unconventional monetary policy, has multiple objectives, several of which could be done better, or could be done by the finance ministry.
Publication history: only at www.jdawiseman.com/papers/finmkts/quantitative_easing.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; What is QE/UMP trying to achieve?; Quotations—central bankers’ objectives in their own words; Can these objectives be better achieved? (Reserves, Trading, Spreads, Direct, Yields, Guarantees); Next Steps; Footnotes.
Several prominent central banks are engaged in actions labelled quantitative easing or unconventional monetary policy (henceforth “QE/UMP”). These terms cover a range of commissions and omissions, with different motivations. To jump to the conclusion: QE/UMP is a muddle, encompassing things that can be done otherwise and more robustly by the central bank, and things that can be done as well by a finance ministry.
This essay refers frequently to the Bank of England, mostly because it is the central bank known best to the author. However, the conclusions apply to the Federal Reserve and to other central banks.
It appears that central bankers have (some not-necessarily-strict subset of) six objectives for QE/UMP, as follows.
To increase banks’ reserves, that is, the amount of money in their reserve accounts at the central bank.
To increase trading and liquidity in some credit instruments, thereby decreasing illiquidity premia.
To tighten credit spreads.
To lend money directly to some favoured set of borrowers (where not constrained by EU single-market rules restricting state aid).
To lower yields on long-term government bonds.
To reduce contagion risks by guaranteeing some entities’ liabilities, or by guaranteeing that those entities can sell assets.
In the following quotations from central bankers, some clauses and sentences are ended by the applicable objectives. (Readers lacking the time or motivation to read all the quotations might wish to jump forward to the next section.)
Speech by BoE Governor, 20th January 2009 (starting page 7)
The conventional approach to such unconventional measures is to buy assets, such as government securities or gilts, which are traded in liquid markets to boost the supply of money Reserves. Provided the additional reserves are not simply hoarded by banks, as happened to some extent in Japan earlier in this decade, such asset purchases can increase the supply of broad money and credit and the liquidity of private sector portfolios, raising spending. The effectiveness of this approach is likely to be enhanced by the clear commitment by the MPC to take the measures necessary to meet the inflation target in the medium term.
In addition to these conventional unconventional measures there are also unconventional unconventional measures. When credit markets are dysfunctional, as some are at present, targeted purchases by the Bank of England of assets may improve liquidity in markets for those credit instruments Trading. The objective of such purchases would be not only to boost the supply of broad money Reserves but also to increase liquidity and trading activity in the markets for those assets Trading. A reduction in the illiquidity premium for a particular credit instrument might help to stimulate issuance by corporate borrowers and the resumption of capital market flows, thus reducing reliance on bank lending. It could also raise the values of assets that are currently under-priced because of high illiquidity premia Spreads, helping to strengthen the balance sheets of banks and other financial institutions.
Inflation Report, February 2009 (page 45)
Such operations would add to the monetary stimulus already in place from the low level of Bank Rate in two key ways:
Macroeconomic Policy Responses in the UK?, speech by David Blanchflower on 29th January 2009 (page 14)
When money markets are dysfunctional, asset purchases by a central bank can help to reduce liquidity premia and restore activity and lending Trading. I would label these type of actions as ‘credit easing’. By changing the composition of the assets and liabilities on its balance sheet a central bank can encourage more favourable lending to households and firms ¿Spreads?—or maybe maturities?. In contrast, the policy pursued by the Bank of Japan in the 1990s, often referred to as ‘quantitative easing’, was primarily focused on the quantity on bank reserves in the economy.
A key goal of these operations might be to restore activity in those markets where lending has ceased Trading and to close the gap between effective interest rates in money markets and the official Bank rate Spreads.
Stability, Instability and Monetary Policy, speech by Kate Barker on 12th March 2009 (page 12)
A change in monetary policy tool was clearly required, which focuses on the quantity rather than the price of money Reserves. And as part of this overall strategy, it was appropriate to take Bank Rate closer to zero, to prevent too much of a gap opening up between Bank Rate and the overnight money market rate, as the latter may drift toward zero as quantitative easing gets underway. This could have encouraged the banks to accumulate reserves, remunerated at Bank Rate, rather than increasing lending.
… there are a range of potential effects which I will be looking at closely over the coming months to gauge the impact of the MPC’s actions. These will include a flattening of the yield curve in the part of the gilts market where purchases will take place Yields, a reduction in the spreads on corporate bonds directly to the extent that these are also purchased Spreads, and a positive impact on a range of asset prices as the sellers of gilts and corporate assets to the Bank find they need to readjust their portfolios away from their higher cash holdings ¿Yields?, ¿Spreads?. Importantly, to the extent that the banks themselves gain higher money holdings, then there should also be a benefit as this will be further support for increased lending growth Reserves.
Bank of England … Announces £75 Billion Asset Purchase Programme, 5th March 2009
… the Committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit … Reserves
The Federal Reserve: Credit and Liquidity Programs and the Balance Sheet
(“Last update: February 23, 2009”)
The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) is a lending facility that … is intended … to foster liquidity in the ABCP market and money markets more generally Trading.
The Commercial Paper Funding Facility (CPFF) is a facility … that enhances liquidity in the commercial paper markets Trading.
The Money Market Investor Funding Facility … is intended to provide liquidity to U.S. money market mutual funds and certain other money market investors, thereby increasing their ability to meet redemption requests and hence their willingness to invest in money market instruments, particularly term money market instruments Guarantees.
… Term Asset-Backed Securities Loan Facility … is intended to assist the financial markets in accommodating the credit needs of consumers and small businesses by facilitating the issuance of ABS collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA) and to improve the market conditions for ABS more generally Spreads, ¿Trading?.
The Crisis and the Policy Response, speech by Chairman Ben S. Bernanke on 13th January 2009
Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy. … I find it useful to divide these tools into three groups. …
The rationales and objectives of our various facilities differ, according to the nature of the problem being addressed. In some cases, as in our programs to backstop money market mutual funds, the purpose of the facility is to serve, once again in classic central bank fashion, as liquidity provider of last resort Guarantees. Following a prominent fund's "breaking of the buck"--that is, a decline in its net asset value below par--in September, investors began to withdraw funds in large amounts from money market mutual funds that invest in private instruments such as commercial paper and certificates of deposit. Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened. The Federal Reserve responded with several programs, including a facility to finance bank purchases of high-quality asset-backed commercial paper from money market mutual funds Guarantees. This facility effectively channeled liquidity to the funds, helping them to meet redemption demands without having to sell assets indiscriminately. Together with a Treasury program that provided partial insurance to investors in money market mutual funds Guarantees, these efforts helped stanch the cash outflows from those funds and stabilize the industry.
The Federal Reserve's facility to buy high-quality (A1-P1) commercial paper at a term of three months was likewise designed to provide a liquidity backstop, in this case for investors and borrowers in the commercial paper market … the functioning of that market deteriorated significantly in September, with borrowers finding financing difficult to obtain, and then only at high rates and very short (usually overnight) maturities Spreads. By serving as a backup source of liquidity for borrowers, the Fed's commercial paper facility was aimed at reducing investor and borrower concerns about "rollover risk," the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased Spreads, ¿Trading?.
In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans Spreads. … By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging and risk aversion in which such capacity appears very short. If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit Spreads. Over time, by increasing market liquidity and stimulating market activity Trading, this facility should also help to revive private lending. …
The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio. For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation Spreads. Lower mortgage rates should support the housing sector Spreads. The Committee is also evaluating the possibility of purchasing longer-term Treasury securities Yields. In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets ¿Yields?, ¿Spreads?. …
The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads Spreads and improving the functioning of private credit markets more generally Trading.
Federal Reserve Policies to Ease Credit and Their Implications for the Fed's Balance Sheet, speech by Chairman Ben S. Bernanke on 18th February 2009
To further ease financial conditions, beyond what can be attained by reducing short-term interest rates, the Federal Reserve has taken additional steps to improve the functioning of credit markets and to increase the supply of credit to households and businesses--a policy strategy that I have called "credit easing." Spreads, Direct … I will briefly outline the three principal approaches to easing credit that we have undertaken, over and above cutting the short-term interest rate, …
Each of these policy approaches involves the provision of credit Direct or the purchase of debt securities Spreads by the Federal Reserve, which collectively have resulted in a substantial expansion in the size of the Federal Reserve's balance sheet. …
These additional components of the Fed's toolkit can be divided into three sets. The first set … enhances the stability of our financial system, increases the willingness of financial institutions to extend credit ¿Trading?, ¿Spreads?, and helps to ease conditions in interbank lending markets Spreads, thereby reducing the overall cost of capital to banks Spreads. …
… the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly to borrowers and investors in key credit markets Direct. Notably, we have introduced facilities to purchase highly rated commercial paper Direct at a term of three months and to provide backup liquidity for money market mutual funds Guarantees. The purpose of these facilities is to serve, once again in classic central bank fashion, as backstop liquidity provider, in these cases to institutions and markets that were destabilized by the rapid withdrawal of funds by short-term creditors and investors. In addition, the Federal Reserve and the Treasury have jointly announced a facility--expected to be operational shortly--that will lend against AAA-rated asset-backed securities collateralized by recently originated student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. … If this program works as planned, it should lead to lower rates and greater availability of consumer, business, and mortgage credit Spreads.
… third set of tools … rates on 30-year conforming fixed-rate mortgages have fallen nearly 1 percentage point since we announced the program to purchase GSE-related securities Spreads.
Swiss National Bank’s Monetary policy assessment of 12 March 2009
The economic situation has deteriorated sharply since last December…. Decisive action is thus called for, to forcefully relax monetary conditions. Against this background, the Swiss National Bank (SNB) is making another interest rate cut and acting to prevent any further appreciation of the Swiss franc against the euro. To this end, it will increase liquidity substantially by engaging in additional repo operations Reserves, buying Swiss franc bonds issued by private sector borrowers Reserves, Spreads and purchasing foreign currency on the foreign exchange markets Reserves if not sterilised. …
By once again lowering the three-month Libor target range to 0–0.75%, by gradually bringing the Libor down to the lower end of this range, i.e. to around 0.25%, and by acting to prevent a further appreciation of the Swiss franc against the euro, the SNB is pursuing its expansionary monetary policy in order to support economic activity and limit the risk of deflation. The temporary narrowing of the Libor target range, which now stands at 75 basis points compared with the usual 100 basis points, is due to the fact that a negative Libor is not technically possible.†1
So, in a complicated multi-faceted crisis there is much the authorities would like to achieve—very reasonable. But are these objectives being achieved in the best way possible? Let us take each in turn.
As the author has argued previously†2, reserves are not a natural thing, and very much the wrong foundation on which to build central-bank operations. The term ‘reserves’ usually means the positive balance in a commercial bank’s reserve account at a central bank, and thus reserves are something that commercial banks can use to make payments.
Instead the central bank should grant each commercial bank a large overdraft limit, such overdrafts to be secured against appropriate collateral. The overdraft rate must be the cheapest way to obtain central-bank money, so that it is free of stigma, and hence either at the policy rate, or if positive balances are remunerated at that rate, an edge above. Then all eligible collateral, valued minus haircuts, can be used to allow a payment: ‘reserves’ thus becoming anything that allows an outgoing payment, equalling money plus haircut eligible collateral.
If this were the rule then each large commercial bank would park tens of billions of collateral with the central bank (why not?—costs nothing), thus having a huge on-demand overdraft limit. System-wide reserves would be hundreds of billions, all achieved without the central bank explicitly adding any. More natural; more flexible; and effective with rates at zero, with rates massively positive, or anywhere in between—and thus more robust.
To encourage an active market in credit instruments central banks are buying such instruments, or standing ready to buy them. This isn’t that bad: the existence of a back-stop bid can reduce the maximum loss faced by market makers and thus increase their willingness to trade.
Many of the credit instruments in existence are not very large (less than a few hundred million), and there is little market activity with which to assess a price (indeed, the latter is the problem that the central bank is endeavouring to repair). Then the central bank buys some of an instrument from a particular investment bank. It is likely that there is an information asymmetry: the investment bank knowing better than the central bank the extent to which the underlying assets are unlikely to pay. Thus there is a real risk, even a likelihood, of a buyer’s curse and the central bank overpaying.
Happily, there is an alternative course of action, an alternative that lessens this information asymmetry, whilst better increasing trading activity. The central bank (or finance ministry) should auction put options on these instruments. Dealers owning these put options would delta-hedge. That is, when the prices fall the dealers would buy, and when prices rise dealers would sell. There would be more trading activity, more stability of price, and more confidence that dealing prices could be found. All these benefits would occur at a lower cost to the public purse.
There are some details that would have to be decided.
The underlying of each put option could be a security. The strike would be denominated in terms of the cash price, quoted in the usual market convention. On exercise the security would be sold for the cash price of the strike.
Or the underlying could be, in effect, a credit spread. The strike for each security could be measured as a yield spread over a particular government bond (matching the currency of denomination of the credit security). In which case, on exercise, the owner of the option would buy that government bond at the then-prevailing market price, and sell the credit instrument at the yield of the government bond plus the strike spread.
The former has the advantage of simplicity; the latter that of capturing just the volatility of the credit and not of the government yield. As credit spreads are far more volatile than government yields, the former should suffice. (Obviously for FRNs and the like the former has the intended advantage of the latter, so quoting the strike as a price would have both advantages.)
Expiry? An expiry of three or six months would be short enough that delta-hedging could still occur, but long enough that many such options (with overlapping terms) would exist simultaneously.
The strike would be near that which the central bank believes is the current price or spread (though it wouldn’t matter if the central bank misjudged this).
Options would be sold by auction—banks should pay for this protection; it shouldn’t be free.
If the authorities wish to tighten credit spreads, the authorities probably need to buy credit instruments. But if the problem of mal-defined reserves were to be fixed, it could then be the finance ministry (the Treasury) rather than the central bank that buys these instruments (though the CB might still act as execution agent). It is not obvious to the author whether it would be better for the buying to be done by the central bank or the Treasury, or even by the central bank with the Treasury’s money, but it is obvious that confusion about reserves means that this decision has not been considered properly. Please could the authorities consider the questions separately?
The author is uncomfortable with the idea of the government, which can too easily mean politicians seeking favours from constituents, lending money directly to favoured entities. Nonetheless, some elements of this, such as loans to car manufacturers, seem to be inevitable.
And if direct lending is to happen, it must happen similarly to the attempt to tighten spreads (so can be done by the finance ministry).
If the authorities wish to artificially lower yields on long-term government debt, it may well fall to the central bank to buy the debt, funded either with short-term debt, or even shorter-term with central-bank money. But re-read the quotations: there are only two references to a desire to lower yields of government debt.
Kate Barker, an external member of the BoE’s MPC: “… there are a range of potential effects which I will be looking at closely over the coming months to gauge the impact of the MPC’s actions. These will include a flattening of the yield curve in the part of the gilts market where purchases will take place”. Is this a real desideratum, or is this just a method of learning whether gilt purchases have had any effect? It may well be the latter, in which case this is not really an objective.
Ben Bernanke: “The Committee is also evaluating the possibility of purchasing longer-term Treasury securities”. Sure, the Federal Reserve is evaluating it: but this isn’t an objective, merely being evaluated as a means to an unspecified objective.
These not-quite hints at near-objectives are not of themselves sufficient to justify central-bank funding of the government.
To reduce contagion risks the authorities might wish to guarantee all or some of the liabilities of certain entities—chief among the suspects being banks and money-market funds. Or the authorities might wish to go half-way, by undertaking to bid some form of fair price for such entities’ assets. Given the time-inconsistency of the public policy, the moral hazard has to be tolerated. But, as with the authorities’ desire to narrow credit spreads, it is not obvious that this must be done with the central bank’s money. Even if the CB is the execution agent, using the Treasury’s money comes closer to admitting that the taxpayer will be taking the losses (or making the profits) from such actions.
However, between here and fixing these matters there lies a problem. As central bankers, especially British central bankers, often comment, expectations are very important, and clear credible commendation can help guide expectations. But now imagine that a central bank were to communicate that a problem it was going to fix at a seeming ‘cost’ of £75bn is instead to be fixed with a zero-cost change to its rules. Some might believe that such as statement would weaken confidence in the competence of that central bank’s operations. That diminution of confidence in competence, whether or not justified, might itself slow an economic recovery. This reasoning alas increases the hurdle that must be overcome before the central bank will acknowledge the dysfunction in the current definition of reserves.
As with so much of the crisis, it would be better if we weren’t starting here.
— Julian D. A. Wiseman
New York, 16th March 2009
†1 Negative Libor is actually possible, and there have been a few negative contributions to the JPY Libor fixing. However, Libor is unlikely to go more than slightly negative: at a price of about –1% it starts to become economic to hold (and guard and insure) physical cash.
†2 Amongst other writings see: The Implementation of Monetary Policy: The Next Attempt, a letter to Paul Tucker sent in November 2008; The Bank of England: a step closer towards its own monetary policy, dated 5th March 2009; and Short-term ‘draining’ operations and the nature of reserves, dated 9th March 2009.
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