The jury is still out on quantitative easing

With the 2014 mid-term election campaign in full swing in October the US Federal Reserve’s decision to ease back on its bond buying program (quantitative easing) didn’t receive the coverage it deserved by the media. So what is ‘quantitative easing (QE) and why is it used? The Economist explains:

When the crisis [GFC] struck, big central banks like the Fed and the Bank of England slashed their overnight interest-rates to boost the economy. But even cutting the rate as far as it could go, to almost zero, failed to spark recovery. Central banks therefore began experimenting with other tools to encourage banks to pump money into the economy. One of them was QE.

To carry out QE central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence “quantitative” easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. The idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment.

So how has QE worked in practice? This is strongly debated by economists with the Wall Journal having canvassed economists for their views on QE. Meanwhile Robert Samuelson over at Real Clear Politics is arguing why more research is necessary.

Take the “event studies.” They observe interest rates only during the first hours or days after a Fed bond-buying announcement. Over longer periods, interest rates may reverse course. On his blog, economist James Hamilton of the University of California, San Diego, says that rates on 10-year Treasury bonds actually rose during periods of Fed bond buying — the opposite of the goal. Whatever the Fed’s influence, he writes, it was overwhelmed by “developments beyond [its] control.”

Likewise, economic models may exaggerate the tendency of lower interest rates and higher stock prices to increase spending. Maybe the financial crisis has made people more cautious. The models may be outdated.

Some of the potential pitfalls of QE are discussed here in analysis by ECR Research. The Economist shares similar concerns.

Studies suggest that it did raise economic activity a bit. But some worry that the flood of cash has encouraged reckless financial behaviour and directed a firehose of money to emerging economies that cannot manage the cash. Others fear that when central banks sell the assets they have accumulated, interest rates will soar, choking off the recovery. Last spring, when the Fed first mooted the idea of tapering, interest rates around the world jumped and markets wobbled. Still others doubt that central banks have the capacity to keep inflation in check if the money they have created begins circulating more rapidly. Central bankers have been more cautious in using QE than they would have been in cutting interest rates, which could partly explain some countries’ slow recoveries.

The challenge for economists is to increase their knowledge of QE by developing more advanced modelling and measurement systems enabling QE to be further refined. As it stands not enough is known about its inner workings and how it influences economies.