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
- 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.