Over the past decades, most of the world’s Central Banks have widely used open market operations to influence the short-term interest rates to achieve their main objectives of controlling inflation and promoting economic growth. Recently, however, the short-term interest rates, in major developed economies, have reached the so-called “zero lower bound” (i.e. they cannot be lowered anymore because with interest rate equal to zero people would simply prefer to keep their money as cash).
In the aftermath of 2008 crisis, the slack of major developed economies pushed Central Banks to implement the so-called unconventional monetary policies, which include the clearer communication by Central Banks of their expectations regarding the future path of short-term interest rates (the so-called Forward Policy Guidance) and the Large Scale Asset Purchases (LSAPs), more popularly known as Quantitative Easing (QE).
Economists have extensively debated these unconventional monetary policies and although currently there is more or less a consensus about the importance of the Forward Policy Guidance, the LSAPs still divide many opinions. The ongoing debate about the LSAPs can be summarized in three questions: Are the LSAPs really effective in lowering interest rates and fostering economic growth? What are the risks and possible unintended consequences of the LSAPs? Do the benefits outweigh the risks?
Several recent empirical studies tried to access the impact of the LSAPs over the interest rates and the economy as a whole. The core evidence presented so far suggests that the LSAPs have had the intended effects. For instance, regarding the impact over the interest rates, D’Amico et al. (2012) estimated that the first LSAP program undertaken by the Fed in 2009 reduced longer term treasury yields by about 35 bp (tantamount to a cut in federal funds rate of about 140 bp), whereas the second LSAP program reduced the longer term Treasury yields by about 45 bp (equivalent to a cut of approximately 180 bp in the federal funds rate).
In what concerns the effects of previous quantitative easing programs (QE) on the overall economy, Williams (2012) pointed out that QE2 program lowered the interest rate by roughly 0.3% compared with what it would have been without the program and raised GDP and inflation by about 0.5% and 0.2%, respectively. Moreover, the author points out that together QE1 and QE2 reduced the unemployment rate by 1.5% and probably prevented US economy from falling into deflation.
Despite the positive evidence over the impacts of the LSAPs, there are serious risks that these policies will materialize in higher inflation rates in the future. The doubts about the incapacity of central banks to implement effective anti-inflationary policies in the future stem from the fact that current grim economic outlook is refraining banks from pumping LSAP’s money into the system, instead they are “parking” those resources as excess reserves in the central banks.
The threat is that, as soon as the economy starts to improve the banks can start to withdraw the reserves from central bank to lend to the public, which would lead to a sudden increase in the money multiplier and, thus, in the monetary aggregates. In such situations the central banks have some options to avoid the inflationary credit expansion, such as, increase the short term interest rates, increase the interest paid on the excess reserves, increase the minimum reserve requirements or even sell part of the assets previously bought.
However, the lack of previous experience with these policies creates a lot of uncertainty. Whether these policies will be sufficient to curb monetary expansion or not is a question mark creating uncertainty and the major risk underlying the LSAPs.
The question of whether the benefits of the LSAPs outweigh their risks is fundamental and will dominate the debates among policymakers and central bankers over the next decades. It is certain that unconventional monetary policies have inflationary risks that perhaps in “normal times” would not justify their implementation. Nevertheless, the combination of impossibility to add fiscal stimulus (either in the politically gridlocked United States or in the highly indebted Euro countries) and the negative economic perspectives that major developed economies now face, in my opinion, justify to bear the risks of these unconventional monetary policies, but this does not mean that those policies can be implemented without the proper caution.
As recently pointed out by the president of the Fed San Francisco, John Williams, “the presence of uncertainty does not mean that we shouldn’t be using these tools. […] However, it should be employed more cautiously than policy tools that have more certain effects”.
Miguel Bandeira da Silva (#59)
Bauer, Michael D. 2012. “Fed Asset Buying and Private Borrowing Rates.” FRBSF Economic Letter 2012 – 16 (May 21). http://www.frbsf.org/publications/economics/letter/2012/el2012-16.pdf
D’Amico, English, Lopez-Salido and Edward Nelson. “The Federal Reserves’s Large Scale Asset Purchase Programmes: Rationale and Effects.” The Economic Journal, 122 (November 2012), F415–F446.
Williams, John C. (2012, November). The Federal Reserve’s Unconventional Policies. Presentation to the Center for Economics and Public Policy (UC Irvine). Irvine, California. http://www.frbsf.org/news/speeches/2012/john-williams-1105.pdf
Yamaoka, Hiromi and Murtaza Syed (2010). “Managing the Exit: Lessons from Japan’s Reversal of Unconventional Monetary Policy”. IMF Working Paper 10/114.
“QE, or not QE?”. The Economist, July 14th, 2012.
 Furthermore, Bauer (2012) by pointed that the past rounds of LSAPs the Fed have lowered not only the yield of the targeted securities (10-year Treasuries and 30-year Mortgage Backed Securities), but also various private borrowing rates such as the conforming mortgage rate, the jumbo mortgage rate and the average yield on investment-grade securities with 7 to 10 years to maturity.
 According to figures from the Fed St.Louis, the amount of excess reserves was $ 1.8 billion in August 2008 is now $1,418 billion.
 For a more detailed discussion on the exit strategies of unconventional monetary policies see, for instance, Yamaoka and Syed (2010) and references therein.