Question: What is quantitative easing ?
Malcolm Barr: With the U.S. Federal Reserve having already cut rates to zero in response to a global recession, and other central banks not that far behind, quantitative easing is on everybody’s minds.
Central Banks typically operate by setting the interest rate at which they will lend to the banking system for very short periods (overnight or for a week or so). When the Bank of England sets its official “Bank Rate” at, say, 1.5%, it is establishing the overnight interest rate at which banks can borrow money from the Bank of England until it is changed again. While the Bank of England sets the ‘price’ of such short term lending, it cannot determine the quantity of such loans. That depends on how much the banks want to borrow. There’s an old adage in economics that a monopoly supplier can set either the price or the quantity of supply, but not both; the central bank has the monopoly on supply of cash to the system.
For a host of practical reasons, it is near impossible for interest rates to fall below zero, making zero the effective floor. So when interest rates reach zero, central banks no longer have to be concerned that the amount of money being provided to the banking system will be too large, pushing interest rates below the desired rate. As a result, they are free to think about policy in terms of the quantity of money they are providing, rather than its price, hence the term “quantitative easing” (QE). And rather than simply making funds available to the banks, the central banks can actively purchase assets from the banking system, supplying more money, and possibly pushing the prices of the assets they buy upward.
Q: How does QE work in practice?
MB: Central Banks typically do not want to get into business of having to choose which types of private sector assets to buy and what credit risks to take on. So in the first instance, QE typically works by the central bank beginning to purchase significant amounts of ‘safe’ government debt with maturities greater than three months or so. That has the effect of raising the prices of such debt, and effectively lowering the relative interest rate for longer maturities, which the central banks typically do not influence.
This time around, however, a number of central banks have already moved toward buying private sector assets, such as the debt issued by firms. That partly reflects the specific difficulties which have occurred in getting credit flowing to corporate borrowers. The worse the economic situation gets, the more likely it is that central banks will purchase larger amounts of more risky types of assets.
Q: What are the possible negative side effects of QE?
MB: In any money-based economy, confidence that the value of cash will be sustained is key.
Some worry that the expansion of central bank money in the system will contribute to a generalized loss of confidence in the stability of the currency, causing inflation to take off. But in the first instance, the money created by the central bank in QE exists largely in book entry form, as higher deposits held by financial institutions at the central bank. It is only to the extent that financial institutions choose to turn their rising holdings of deposits at the central bank into physical cash - perhaps because rising prices means their customers need more cash to conduct transactions – that QE can turn into “printing money”.
At this stage few economists believe QE carries significant short term inflation risk. Indeed, the weakness of demand in global economies suggests deflation rather than inflation is more likely to take hold. Over the longer term, however, there is more room for concern. The weakness of growth and actions to fight that weakness are causing the public sector to expand its debt in various forms (both issuing government debt and creating money). Most of that debt is a liability whose value is fixed in nominal terms. That larger the extent of those liabilities, the greater the incentive to ‘create’ inflation, to reduce the real burden of that debt over time.