When rates get to zero, what happens next? Quantitative easing
Later today the Fed will probably cut US rates by 0.5%, down to 1%. After this we’re only a couple of cuts away from a zero percent Fed Funds rate. When rates are at 0%, what can a central bank do to stimulate the economy? Well some possible answers are found in Japan, although with its economy still struggling to print positive growth numbers a full 18 years after its bubble burst, it may not be the best role model. In March 2001, with Japanese short term rates at 0.15%, the Bank of Japan (BoJ) began a quantitative easing programme. With traditional monetary policy no longer effective (the so called liquidity trap), how could the BoJ stimulate economic activity? It flooded the economy with money by buying financial assets (bills, equity, ABS), and in so-called Rinban operations directly buying Japanese Government Bonds. Rinban operations were designed to make monetary policy effective at longer dated maturities than traditional central bank activities. By buying long dated government bonds the hope was that yields would be pulled down across the curve, and thus reduce borrowing costs for corporates and individuals where loans were benchmarked over government bond yields. The BoJ purchased about $120 billion JGBs per year as part of the plan.
Did it work? Quantitative easing ended 5 years later, with the BoJ having reached its stated aim of returning the economy to inflation (although it did subsequently return to deflation once more). Long dated (20 year) JGB yields did fall too, from about 1.8% in March 2001 to below 1% a couple of years later – but by the time quantitative easing came to an end yields were back up above 2% again, so it’s arguable whether this part of the plan was very successful.
Is quantitative easing something that the western economies will consider? Well to some extent it’s already here – central banks have turned on the printing presses (the $80 billion to bail out AIG for example), are flooding the money markets with liquidity, and have started to buy financial assets (the equity stakes in banks for example). Purchasing of US Treasury bonds might not be too far behind – and remember that the Fed discussed it once before around the time of the 2002 deflation scare. The FOMC talked about "unconventional measures" including purchasing many types of financial assets (and non-financial too – it’s rumoured that they discussed using the secondhand car market as a means of getting cash into the hands of the American public). The June 2002 Fed paper, Preventing Deflation: Lessons from Japan’s experience in the 1990s, is well worth revisiting as a route map for the next few years.
And this might well be a story that takes a few years to unfold – it seems difficult for us to believe that the amount of fiscal stimulus, rate cuts, printing press activity and bank recapitalisation thrown at the global economy won’t result in a sharp rise in inflation, but the Japan experience shows that even then the most extreme measures can’t guarantee that the authorities can generate a bit of lovely inflation.
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