These days, all over across the Wall Street and academia, many economists touch an extremely hot topic days: the quantitative easing policy. The world economy is facing the toughest recessionary pressure since the Great Depression and that calls for an unprecedented monetary policy from the central banks. Since June 29th 2006, when the federal target rate reached 5.25 percent, Federal Reserve has engaged into a monetary easing policy that took the benchmark interest rates in the vicinity of zero. Similarly, Bank of England has reduced the benchmark rate to half a percentage point, and European Central Bank adopted a dovish stance with interest rates down to historical low levels of 1 percentage point. On top of that, Fed has injected massive amount of liquidity into the financial system through the discount window loans, term-credit loans to banks and currency swaps to foreign central banks. As an extraordinary set of measures, from the beginning of the year Federal Reserve has announced two special programs: a program to purchase up to $300 billion of longer-dated Treasury securities and a program to purchase $1.25 trillion of agency mortgage-backed securities.
The goal of these historic programs was primarily to improve conditions in the credit markets alongside with supporting the ailing housing market through the mortgage origination business. All the aforementioned liquidity injection measures corroborated with the asset-purchasing programs have expanded Fed’s balance sheet to almost $2.1 trillion. Nonetheless, from the beginning of 2009, banks’ access to funding vehicles and the general credit markets have improved constantly. The total volume of Fed’s lending to banks has decreased by almost 50 percent from January 1. The credit spread over the Treasury yield required by the investment-grade corporate bond investors has been reduced to 409 basis points from almost 600 basis points in March. A basis point is 0.01 percentage point. Despite the Treasury bond purchasing plan announced by the Fed, global markets reacted negatively, driving the yield on the benchmark 10-year Treasury bond from a level of 2.60 percent to 3.74 percent. That significant spike equates in higher mortgage rates for the consumers and higher borrowing cost for corporations. Both negative effects will ultimately delay US economy recovery and they will make Fed’s job extremely difficult. Without an improved job market, Federal Reserve cannot change its aggressive monetary policy and subsequently it will continue adding hundreds of billions of dollars worth of assets on their balance sheet.
In early February, Bank of England argued at their meeting that the time was now right to use “alternative policy instruments” — notably quantitative easing — because more interest rate cuts “could not inject sufficient stimulus” in the economy. In May 2009, Jean-Claude Trichet emphasized that the ECB will be embarking on a credit easing policy as opposed to a quantitative easing. According to the modern theory, credit easing aims at affecting the risk spread across assets, whereas quantitative easing aims at affecting the general level of the longer-term interest rate. The ECB move should be enough to positively affect the market for euro-denominated covered bonds while the effect on the overall bond market is likely to be muted. Trichet also announced that the European Investment Bank will get access to central bank liquidity. This move will help to increase investment in vulnerable sectors and regions. It is not targeted at alleviating government budgets and will do little in this respect.
According to the macroeconomics theory, when the overall economic conditions are worsening, the central banks adopt an expansionary monetary policy with the goal of expanding the money supply. In order to pump liquidity into the system central banks have three available tools: purchasing securities on the open market, lowering the benchmark interest rates and lowering the reserve requirements. Ben Bernanke – the chairman of the Federal Reserve, published in 2005 the book entitled “Essays on Great Depression” where he extensively explored that financial crisis. To avoid the mistakes of 1930s, when the Fed restricted the money supply at a time when economic output was slowing, the central bank has orchestrated a laborious monetary policy. Today monetary policies could have additional effects on the economy, via so-called credit channel, because interest-rate decisions affect the cost and availability of credit. The credit channel has two components: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). According to the Pure Expectations Theory, the slope of the Treasury yield curve reflects only investors’ expectations for future short-term interest rates. With a current upward slope of the yield curve investors are pricing an increasing level of inflation and subsequently a change in Fed’s monetary policy. At this time, the macroeconomic theory teaches us that the central bank should continue expanding its balance sheet that will ultimately flatten the yield curve. The current near-zero level for the interest rates and the massive Fed liquidity injection programs will turn the economy around by strengthening the consumer spending. Higher expectations for growth will drive-up the aggregate demand and ultimately it will reduce the unemployment rate.
It is well-known that the central banks have a very difficult mission ahead. Over the years, the capital markets reaction has become the best barometer for the central banks monetary policies. Consequently, central banks around the world should continue to pour liquidity into the financial system. By extending such programs over other classes of assets, the central banks might turn an asset that may be illiquid for the lender into a liquid asset. This may be particularly helpful in spurring aggregate demand should the financial sector be under stress and in need of liquefying its assets.
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