QE or not QE, that is the question

Today’s publication of the latest FOMC minutes will probably unveil significant downward revisions to the Committee’s inflation and gross domestic product forecasts for 2011, as well as a large upward revision to its unemployment forecast. More interestingly, the minutes will show whether the FOMC is broadly united on the strategy of quantitative easing which it has now adopted. Is the FOMC clear about how QE is intended to work? I raise the question because Mr Bernanke’s most recent speech made the rather startling claim that the policy should not even be called “quantitative easing” in the first place. Not all of his colleagues on the FOMC, and few of his outside critics, appear to agree with him.

The term “quantitative easing” first came into prominence about a decade ago, when the Bank of Japan was being urged by economic commentators to take direct measures to increase the money supply, after its zero interest rate policy had failed to reverse deflationary forces in the economy. In an article co-authored by Mr Bernanke in 2004, the Bank of Japan was defined as conducting a policy of QE when it “added liquidity to the system beyond what is needed to achieve a (short term interest) rate of zero”. The Bernanke paper suggested that this was normally done “through open market purchases of bonds or other securities which have the effect of increasing the supply of bank reserves”. These are the standard definitions, which have been widely used by economists ever since.

Compare this with what Mr Bernanke said last week:

In my view, the use of the term “quantitative easing” to refer to the Federal Reserve’s policies is inappropriate. Quantitative easing typically refers to policies that seek to have effects by changing the quantity of bank reserves, a channel which seems relatively weak, at least in the U.S. context. In contrast, securities purchases work by affecting the yields on the acquired securities and, via substitution effects in investors’ portfolios, on a wider range of assets.

The Fed chairman is here making a distinction, not about the content of the policy, but about its intended effects. After all, what the Fed is now doing – buying bonds and expanding bank reserves – is identical to what the BoJ did a decade ago. However, the BoJ intended the increase in bank reserves to lead to a wider increase in monetary growth in Japan, and this was seen as the mechanism by which QE would stimulate the economy. Mr Bernanke is saying that this mechanism will not operate in the US, but he still expects QE to work by reducing bond yields and raising asset prices, both of which would have stimulatory effects.

Is this right? Should we all now cease using the term “quantitative easing”, and henceforward use the Fed’s catchy alternative of “LSAPs, or large scale asset purchases”, instead? Not in my book.

The Fed chairman has faced a great deal of recent criticism for printing money to finance part or all of the US budget deficit. Therefore he has a strong motivation for making his current policy stance appear as conventional as possible, which means that he wants to describe it as a policy which works through the traditional route of lowering interest rates. The only difference, he argues, is that policy is now aimed at lowering bond yields instead of short term money market rates.

But surely this is not the only difference. The current strategy reduces long term interest rates via a massive extension of the Fed’s balance sheet, which did not happen at all (or hardly at all) when it changed short term rates in more conventional times. It is the change in the size of the Fed’s balance sheet which clearly places the policy in the “quantitative easing” category. This is what leads to an increase in the monetary base, and it is the reason why it raises a lot of extra complications and risks.

If the Fed wished to influence the level of long term bond yields without increasing its balance sheet or the monetary base, it could sterilise the monetary effects of its bond purchase operations. To do this, it would add a further leg to the strategy, selling short dated bills into the market to mop up the liquidity effects of its bond purchases. By doing this, its policy would become a pure interest rate strategy (a yield curve play). And because the central bank’s balance sheet would not be increased, the overall manoeuvre could not be called quantitative easing. But the Fed might not be able to hold short rates close to zero if they sterilised their bond purchases, which is presumably why they have not been able to follow this route.

Mr Bernanke has some very good arguments about how QE can be expected to work in practice, and about why it will not lead to a runaway increase in the broad money aggregates or a surge in inflation. But he will only annoy his critics by seeking to re-label a strategy which so clearly involves a deliberate increase in the size of the Fed’s balance sheet.  This particular duck looks like quantitative easing, smells like quantitative easing – and actually is quantitative easing.

Related reading:

Time to revamp the Fed’s flawed mandate – Stephen Roach in the FT
US economy shows faster growth – FT news story
Money Supply – FT blog on central banks