Monetary Policy Prescription

Comprehensive independent analysis of the financial and global markets news

We also found that consumer price inflation did not materialize despite this being a possible adverse effect. This is probably attributed to the fact that the 2008 financial crisis also prompted a demand crisis. In this recession, prices fall as a result of declining demand.

The Fed did not see any inflationary risk, either. The Federal Reserve feels comfortable with low inflation expectations. Lower consumer prices making consumers feel “richer” may create further demand.

However, businesses have no pricing power. This does not bode well, with high unemployment showing that businesses still need to keep prices under control. Falling prices in conjunction with weak demand will further pressure the businesses’ debt burden with respect to income, requiring more services or goods to be provided to repay their loans even with low interest rates.

The Federal Reserve provision of liquidity did spur consumption, investment in some class of assets (e.g. equity) and generated positive economic momentum. However, a weak labor market indicates that the quantitative monetary policy easing was not strong enough to boost prices and keep economic momentum going.

With the recovery running out of steam, policy analysts and media outlets are proposing a host of monetary policy prescriptions, focusing on restarting Quantitative Easing by massive large-scale purchases of mortgages or government bonds. In particular, they have the notion that the proposed monetary policy drives down long-term interest rates and influences expectations of future short-term interest rates.

However, with falling prices and the prospect of deflation, expansionary monetary policy may be constrained. Deflation can adversely affect borrowing costs and investor’s perception that the business-cycle risk is increasing. Investors then attempt to increase their holdings of low-risk assets and shrink their new investments in businesses. Under these conditions, the risk premium in interest rates of low-risk assets (such as government bonds and high-grade corporate bonds) decreases, but those of high-risk assets (low-grade corporate bonds) increases.

Under these circumstances, the Quantitative Easing by provoking portfolio-rebalancing might not provide enough support to stimulate new investment growth and to keep economic momentum progressing. However an expansion to quantitative monetary policy easing by doing portfolio-restructuring that boosts corporate finances deserve further consideration. Under this proposed policy, the Federal Reserve purchases short-term corporate bonds up to six months maturity. The purchase of corporate bonds it is not limited to highly-credit rated corporate bonds, but also includes low-grade corporate bonds. Purchase of short-term corporate bonds reduces risk exposure due to duration limitation. The effects resulting from open market purchase of short-term corporate bonds limits the credit spreads on low-grade corporate bonds at a time when the corporate financing environment is under pressure. This will provide a stronger base for businesses to invest and create a sustainable recovery at a time when bank debt is not freely available.

With the prospect of deflation, monetary policy alone without strong fiscal policy has a marginal effect in stimulating the economy. By expanding Quantitative Easing by doing portfolio-restructuring purchasing corporate bonds, the Federal Reserve will expand the beneficial effects directly into the corporate financing environment. The Feds choice is limited, by cutting out the stalled banking system and applying QE directly to businesses they have the best chance of creating a beneficial shock to the system and some measure of sustainable growth.

With few clubs in their golf bag, the Fed should apply QE more directly by buying corporate bonds in an effort to spur business investment, consumption and generate positive economic momentum

Last Friday’s weak jobs report, a sign that the labor market is losing much of its momentum, raises questions about whether the economic recovery is running out of steam. Also, two weeks ago, when Fed Chairman Ben Bernanke testified on Capitol Hill, he downgraded his view on the economy.

The Federal Reserve monetary policymakers are confronted again with the issue of what they should do and what they can actually achieve to stimulate the economy when the federal fund rate is near zero.

Should the Fed restart massive large-scale purchase of long-term government bonds, or mortgage-backed securities? Did the initial program work well or are any adverse effects of this policy further down the track?

When the Federal Reserve initiated Quantitative Easing in 2008, as the financial crisis intensified, it expected that portfolio-rebalancing resulting from the open market purchase of long-term government bonds would stimulate the economy. The capital positions of private-sector financial institutions had been weakened by an accumulation of nonperforming loans following a fall in asset prices. As a result, financial institutions were reluctant to take on portfolio risk. The outright purchase of long-term government bonds by the Fed means that a portion of the holdings of long-term government bonds by financial institutions is converted to monetary base.

Our assessment on the actual effects of quantitative easing in preserving financial market stability follows:

Firstly, the program lowered the longer-term interest rate that is expected to lead to economic stimulus. The decline in the long-term interest rates also reduced the expected default rate by reducing the borrowing rate.
Secondly, the abundant provision of liquidity made money market participants feel more secure about the ongoing availability of funds. Uncertainties about conditions in money markets might, at times, lead to elevated demands for liquidity. This led to reducing the probability of a liquidity shortage, and consequently reduced liquidity premiums.
Thirdly, stock prices benefited from quantitative easing. We find that Quantitative Easing affected stock prices by decreasing volatility. However, this appreciation seems to be attributable to a strengthened perception that the financial market has stabilized and expectations of a US economic recovery. Also, contributing factors are the risk-diversification motive and higher returns compared to low interest rates.

As presented below, the Quantitative Easing did stabilize financial markets and revive consumption, respectively, boosting the economy. We observe so far that the Personal Consumption component of GDP grew relative to the increase in monetary base. Reducing the cost of consumer borrowing in conjunction with a strengthened perception of improved financial market conditions encouraged consumption.

In contrast, a lower interest rate and abundant provision of liquidity did not stimulate new investment growth. As presented in the graph below, the Fixed Investment component of GDP stayed almost flat relative to the increase in monetary base. The perception of prolonged recession made businesses more reluctant to take risks. Such reluctance dampens business demand for new investment.