Quantitative Easing

The Great Central Bank Experiment

Jonathan Ashworth

• Publisher: Agenda Publishing
• Year: 2020
• ISBN:
  9781788213370
• Topic: Economia
• Subtopic: Macroeconomia

Before the Great Financial Crisis of 2008–09, significant reductions in official interest rates typically proved sufficient to generate sustainable economic recoveries from downturns. However, with economies and financial markets in freefall during the crisis despite a cut in interest rates to effectively zero, policymakers in some advanced economies launched a major new tool called quantitative easing (QE). This involved central banks purchasing huge amounts of financial assets.

This book offers a thorough and perspicacious analysis of QE, which has become a recovery method of last resort. Whilst it was successful in averting another Great Depression and stimulating growth, it remains controversial and continues to promote widespread debate in economics, financial, and political-economy circles. This book is essential reading for anyone wishing to understand central banking in the national economy.

1

Monetary policy-making since the end of Bretton Woods

The Bretton Woods system of quasi-fixed exchange rates that had been in place for much of the period since the end of the Second World War finally came to an end in early 1973. Under Bretton Woods, the value of the US dollar (USD) had been fixed against gold while other currencies such as the British Pound (GBP), German Deutschmark (DM), etc. were pegged against the USD, with only periodic adjustments permitted in order to help countries correct deficits in their balance of payments. Its demise led to the major industrialized countries allowing their currencies to float freely on global financial markets.¹ The move from fixed to flexible exchange rates allowed national policy-makers to shift from having to use economic policy to help maintain the economy’s external balance (the balance of payments and the exchange rate peg),² to a primary focus on using it to better achieve the economy’s internal balance (stimulating/dampening aggregate demand, achieving full employment, etc.).³

The main tool used by policy-makers to manage aggregate demand and control inflation since the end of Bretton Woods has been monetary policy, particularly official short-term interest rates. This primarily reflects the fact that changes in interest rates are much easier to enact and typically impact the economy much faster than fiscal policy. Indeed, for obvious electoral reasons politicians are typically averse to raising taxes or cutting government spending to slow growth, while to avoid wasteful spending or what are commonly referred to as “white elephant” projects, it can often take considerable time to plan and start new infrastructure projects when activity needs stimulating. Tax cuts have remained a favourite recession fighting tool in the US, although a number of economists have questioned their effectiveness, suggesting that they are more likely to be saved (Rivlin 2015).⁴ Meanwhile, countries where the power to enact fiscal stimulus does not lie solely with the executive branch of government, such as the US, may suffer resistance to and/or delays in passing timely legislation.

For much of the second half of the twentieth century, most central banks did not always have significant leeway to set monetary policy independently of their governments, often facing pressure to maintain interest rates lower than they may deem optimal to control inflation in order to support growth and/or limit the government’s borrowing costs. Among the major central banks, only the German Bundesbank had a truly independent monetary policy (despite the exchange rate constraints until the end of Bretton Woods), which had been enshrined in law in 1957 (Issing 2005, 2018). The 1951 Fed-Treasury Accord had re-established a degree of independence for the US Federal Reserve (Fed), but its Chairmen still faced significant pressure from Presidents in the 1960s and 1970s to be more accommodating with policy (Thoma 2017). In the UK, the final decision on interest rates was made by the government with the Bank of England (BoE) acting in an advisory capacity (Goodhart 2010a). Following on from the work of Phillips (1958),⁵ policy was typically set on the assumption of a downwards sloping “Phillips Curve” relationship, which posited a long-run inverse relationship between the unemployment rate and wage inflation (Jevcak 2014); a lower unemployment rate leads to rising wages and consequently higher inflation. Policy-makers typically utilized this relationship to decide on an acceptable trade-off in terms of the amount of additional inflation they were willing to tolerate in order to boost output and employment by a certain amount (Samuelson & Solow 1960).

A new framework for monetary policy: central bank independence and inflation targeting

The first decade after the end of Bretton Woods saw soaring inflation across the major economies in what is commonly referred to as the “Great Inflation” (see Figure 1.1). Inflation rose from under 4 per cent in the US in January 1973 to over 13 per cent by the end of the decade, with an eventual peak of almost 15 per cent in March 1980. In the UK, inflation rose from around 8 per cent in January 1973 and peaked at almost 27 per cent in August 1975. German inflation also rose, but by much less than elsewhere, rising from 6.3 per cent in January 1973 to a peak of almost 8 per cent in December 1973. Central banks attempted to tighten monetary policy in order to contain the rising inflationary pressures, which resulted in soaring official nominal interest rates. The US effective federal funds rate (FFR) and the BoE’s Bank rate rose from 5.9 and 8.75 per cent in January 1973 before ultimately peaking at almost 20 per cent in the early 1980s. Official nominal interest rates peaked at a much lower level of almost 10 per cent in Germany, although given much lower inflation, German real interest rates were materially higher than in the US for much of the period⁶ (European Central Bank (ECB) 2010) (see Figure 1.4).

The Great Inflation led to a breakdown in belief in the Phillips Curve as both inflation and unemployment had moved sharply higher in most countries in what was commonly dubbed “stagflation”. It also fuelled significant debate and research into why the major central banks, with the exception of Germany, were either unable or unwilling to keep inflationary pressures in check (Issing 2018). An in-depth discussion of the Great Inflation is beyond the scope of this book. For a superb exposition, see ECB (2010), where the authors critique conventional wisdom that “bad luck” amid the massive oil price shocks in 1973 and 1979 was the predominant driver. They stress instead the importance of policy mistakes in countries such as the US and highlight the far superior inflation performances in countries such as Germany and Switzerland, where the central banks placed a much greater emphasis on controlling inflation rather than supporting output. They highlight the introduction of monetary targets by the German Bundesbank as helping to anchor price and wage-setting expectations in the second half of the 1970s in contrast to most other countries, which lacked credible monetary anchors after the end of Bretton Woods. Jordan (2017) suggests the high degree of independence from political interference seems to have played an important role in the superior performance of the Bundesbank and the Swiss National Bank.⁷

The relative success of the independent German Bundesbank in containing inflation during the 1970s, important academic work and the success of the independently minded Fed Chairman Paul Volcker in culling US inflation in the early 1980s helped shift the institutional debate in favour of greater independence for central banks in setting monetary policy.⁸

Figure 1.1. Developed market inflation (%Y)

Source: IMF.

Seminal academic work by Kydland and Prescott (1977) explored the time inconsistency problem in economic policy-making. They highlighted that because private sector agents anticipate the incentive of politicians to try and unexpectedly generate short-term inflation in order to reduce unemployment, they would always factor this into their wage- and price-setting behaviour. As a result, inflation would consequently be higher than desired without any resultant reduction in unemployment. Therefore, rather than setting monetary policy in such a discretionary manner they suggested that it is optimal for policy-makers to compel themselves by policy rules⁹ or commitments to maintain low inflation in the beginning, which by tempering price and wage setting would help them in their task. Barro and Gordon (1983) and Rogoff (1985) expanded on this, with the former suggesting that it is possible that the reputation or credibility of policy-makers (or the potential loss of it) could support or possibly substitute for formal policy rules, while the latter suggested that countries could benefit from choosing an independent central banker that is more inflation averse than the society as a whole given the favourable impact this would have on the private sector’s inflation expectations (although not one so inflation averse that negative supply shocks are primarily absorbed by lower employment). Moreover, important empirical work showed that greater independence for central banks resulted in lower inflation without any resultant reduction of output (Grilli et al. 1991 and Alesina & Summers 1993).¹⁰

Figure 1.2. US Inflation and Effective Federal Funds Rate, %

Source: Board of Governors of the Federal Reserve System, IMF, Federal Reserve Bank of St. Louis (FRED).

Meanwhile, the appointment of Paul Volcker as the new Fed Chairman in August 1979 fuelled a major shift to more restrictive monetary policy in an attempt to tame runaway inflation. Bernanke (2005a) cites US President Jimmy Carter’s appointment of the renowned “inflation hawk” Volcker as the inspiration for Rogoff’s work on credibility. Under Volcker, the Fed placed greater emphasis on restraining money supply growth from October 1979. This fuelled soaring interest rates with the effective FFR peaking at over 19 per cent during 1981 (see Figure 1.2), pushing the US economy into a short recession in January 1980 and then a much deeper and longer recession from July 1981. But it ultimately resulted in inflation falling back under 4 per cent by the end of 1982 from over 12 per cent in October 1979 (Walsh 2004). Thoma (2017) suggests that “Volcker’s success in bringing down the inflation rate cemented the idea that an independent Fed could do what elected officials could not. Thereafter, it became conventional wisdom that the Fed should run free”. A number of other countries targeted the growth in their money supply as a means to control inflation in the 1970s and 1980s;¹¹ however, this practice fell out of favour amid the short-term instability of relationships between monetary growth, nominal incomes and inflation (Goodhart 2010a).

New Zealand was the source of the next major innovation in monetary policy-making. Goodhart and Lastra (2018) note that the introduction by the government in 1989 of a framework combining operational independence and an inflation target for the Reserve Bank of New Zealand (RBNZ) rapidly caught on over the next few years as best practice for central banks around the world. This (and close alternatives) continues to remain the framework used by most of the world’s central banks. Operational independence (also referred to as instrument independence by Debelle & Fisher 1994) means that central banks typically have significant flexibility to choose which tools they want to use and can decide on the magnitude of any changes in the settings of those tools in order to hit the goal or objective set by their governments. In addition, their room for manoeuvre is not constrained by the compulsion to finance government borrowing (Balls et al. 2018). Prior to the Great Financial Crisis (GFC) they would typically decide by what amount to change interest rates (for example, raise/lower interest rates by 25 basis points (bps); a quarter of a percentage point), but post the GFC their toolkits have also included QE and forward guidance.

Most major central banks do not have political independence, however, which Balls et al. (2018) define as “the absence of the possibility for politicians to influence central bank goals or personnel”. Indeed, Goodhart and Lastra (2018) stress the continued ability of governments to redesign existing monetary arrangements (except the ECB) including changing central bank mandates/targets, revoking independence, etc. and politicians’ control of top appointments where a President/Prime Minister could purposefully choose a Chair/Governor whom it is widely known favours very easy monetary policy. For example, in the US the Fed’s mandate or goal is set by the Congress and the Fed Chair, Vice Chairs and Governors are chosen by the President and confirmed by the Senate.¹² A notable recent example of significant political influence being exerted over an operationally independent central bank is Japan (see Chapter 3). Most studies find that, in developed economies, there is a negative statistically significant relationship between the degree of operational independence of central banks and inflation, but no relationship between measures of political independence and inflation (Debelle & Fisher 1994; De Haan & Kooi 1997; Balls et al. 2018).

Most countries have now adopted inflation targets. Of the major developed central banks, the Fed does not have an explicit inflation target as its primary goal; it has instead a “dual mandate” to achieve both maximum employment and stable prices. In 2012, it announced that an inflation rate of 2 per cent is most consistent over the long-run with the price stability part of its mandate. In Europe, the ECB has set interest rates independently since the launch of the euro in 1999 with its primary objective being to maintain price stability, which it clarified in 2003 as meaning inflation at “belo...