The unconventional Monetary Policy at Zero Lower Bound : an empirical analysis of “Quantitative Easing” in Japan and US

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The Unconventional Monetary Policy at Zero Lower Bound:

An Empirical Analysis of “Quantitative Easing” in Japan and US

Janet Zhang (5683327)

Supervisor: Dr. Christian A. Stoltenberg

Program: International Economics and Finance

Date: 2015/08/26

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Abstract: Confronted by the severe financial crisis in 2008, many central banks in leading

industrial countries switched their monetary policies from the tradition to use interest rate as the main tool, to different tools summarized by the notion of unconventional monetary policy, or Quantitative Easing (QE). This paper examines the effectiveness of the first QE rounds in Japan and in the U.S. In particular, the thesis discusses potential optimal monetary policies. We conclude that QE played a positive role in preventing further damage to the financial market, but its overall long-time impacts remains controversial. The potential alternative optimal monetary policy is still in study and expected to breakthrough with growing experiences from experimenting QE worldwide.

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The Global Financial Crisis of 2007-2008, which started in U.S., is generally considered by most economists to be worst crisis in global history, including the Great Depression of the 1930s. On September 15, 2008, one of the most important and most powerful investment banks in the world, Lehman Brothers filed for bankruptcy, amid the global mortgage meltdown that triggered a cascade effect across the financial market. In the aftermath of the Lehman brothers’ bankruptcy, the collapse of other large financial institutions appeared a likely scenario, and the stock prices dropped worldwide. Thus, the stability of the overall financial system came into severe difficulties. In response to the crisis, The Federal Reserve aggressively implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. In December of 2008, the Fed hit the zero lower bound (ZLB), when it dropped its target for the federal funds rate to between 0% and 0.25, thus, the “traditional” conventional monetary policy was at its maximum potential to stimulate economy.

In such extraordinary times, major central banks around the world were forced to act swiftly and to begin experimenting with other tools to control the economy, one of them was Quantitative Easing Policy (QE). The central banks execute QE by buying large scale of assets from commercial banks and other financial institutions, the policy is designed to directly inject money into the economy, and is known as the representative method of unconventional monetary policy. On November 25, 2008, the Fed announced a purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt. Later in march of 2009, the program was expanded by an additional $750 billion in purchases of agency MBS and agency debt and $300 billion in purchases of Treasury securities. However, U.S. is not the first country experimented QE policy, it was firstly introduced by the Bank of Japan in 2001 after decades of recession. It is no surprise that economists carried out numerous studies on the topic, trying to learn lessons from the previous experiences and continue seeking optimal monetary policy under severe circumstances.

This paper studies the implementations of first rounds of QE policy in both Japan and U.S. By comparing them and their consequences, the paper tries to evaluate the effectiveness of QE policy

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under extraordinary economic conditions. On basis of that, an alternative optimal monetary policy under ZLB is discussed as well. The paper is divided into the following parts: Section 1 studies the situation of ZLB, which is so called the “liquidity trap”. The paper explains the necessaries of implementation of QE policy by studying the fundamental elements effecting long-term interest rates; Section 2 reviews the empirical evidences of the first rounds’ applications of QE policy in Japan and U. S., during 2001 to 2006 in Japan, and from 2008 to 2009 in U.S. respectively; the third Section discusses the effectiveness and drawbacks of QE policy, and investigates the alternative optimal monetary policy by reviewing previous academic researches; an overall conclusion is drown in the last section.

2. The Rationale for Quantitative Easing

2.1 Liquidity Trap & Unconventional Monetary Policy

In normal times, central banks conduct conventional monetary policy by setting a target for nominal short-term interest rate and adjusting the supply of central bank money to that target through open market operations. By steering the level of the interest rates, central banks effectively manage the liquidity conditions and maintain stability of financial institutions. But when experiencing powerful economic shock or great economic recession, the nominal interest rates need to be brought down to nearly zero. Thus, cutting interest rates is not possible, because people can simply choose to hold real money instead of depositing it in a bank, since the opportunity cost of holding money disappeared, and currency and any interest-baring asset become perfect substitute. The situation is referred in term of “liquidity trap”, which was firstly elaborated by Keynes (1936), however the phenomenon was recognized as early as 1896 by Irving Fisher (1896).

As the consequences, the traditional interest rate-target policy is limited, because a fall in nominal interest rates cannot increase the demand of money as the MD curve becoming flat. (See Figure 1)

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To investigate possible solutions to escape the liquidity trap, we go back to the fundamental structure of long-term interest rates, the n-year real yield on a bond can be presented as following:

Where is the expected real yield at time t on an n-year bond;

is the average expected overnight rate over the next n years at time t;

is the term premium on an n-year bond at time t;

is the expected average rate of inflation over the next n years at time t. Soure: Fawley and Neely (2013), “Four Stories of Quantitative Easing”

The equation suggests there are three ways to achieve a decline of long-term real yields: 1) increase expected inflation; 2) the expected policy rate path can fall, and 3) to reduce the term premium (Fawley and Neely, 2013). To change the expected inflation, central banks can commit to zero interest rates policy over the period, which Eggertsson (2006) refers to as “committing to be irresponsible”, and it is in term of the “signaling effect”. But the economy is estimated to return to the normal policy when it is recovered from recession, to solve this time inconsistent problem, central banks can conduct unconventional monetary policy. The straightforward way is for central banks to directly purchasing assets from public, as in term of “Quantitative Easing (QE)”, see Figure 2 below:

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Figure 2 How QE works to impact long-term interest rates

Further path of short-term interest rates Risk premium

2.2 Quantitative Easing Policy

Many central banks----among them the Bank of Japan (BoJ), the Federal Reserve (Fed), the Back of England (BoE) and the European central banks (ECB) in recent years, turned to QE policies, which dramatically increase the monetary bases, to alleviate financial distress or promote economic activities. The central banks buy assets, usually government bonds from both public and private sectors with the new money they “created”, to increase the amount of cash in the financial system, stimulating economic activities, and ultimately the economic growth. The QE policy is summarized in Figure 3.

Figure 3 the implementation of QE policy

There are numerous academic researches on the subject of the recent QE programs. Gagnon et al. (2011) found that large-scale asset purchase (LSAP) announcements reduced U.S. long-term

Commitment to maintain zero interest rate

Expansion of CB’s balance sheet (Monetary base)

Changes in CB’s asset composition

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interest rates by studying Fed’s QE program during 2008 to 2009. Hamilton and Wu (2011) indirectly calculated the effects of Fed’s QE of the same period with a term structure model. The details of QE programs varied across countries, depending on the specific structures of their economies and the particular motivations for conducting QE policy. In next section, this paper discusses the effectiveness of QE program by examining the details of the policy applied by the Bank of Japan between 2001 and 2006 and the first round of QE conducted by the Fed in the recession that started in 2007.

3. Empirical Analysis of Implementations of QE policy

3.1 Japan’s QE policy application during 2001 to 2006

1) Background before QE application

After the Second World War, Japan started to implement extensive social reformation. From then on, Japan started to broadly develop the economy; the country realized tremendous growth for the coming ten more years. In 1988, according to the ranking from the newspaper “Businessweek”， among top thirty world enterprises, 22 enterprises are from Japan. In 1991, GDP per capita was USD $28,000; whereas, in the U.S., it was USD $23,000. Before the bubble burst, the total asset of Japan reached to 47,916 billion, surpassing that of the U.S., which was 46,814.2 billion, and the asset prices experienced an enormous bubble during the time. However, entering 1990s, Japan’s rapid growth came into stagnation. The economic bubble soon burst that the Japanese economy came into a complete halt. Thus, both stock and property prices was on a downward trend for the next two decades. By the early 2000s, property prices fell about 60 percent comparing their peak in 1990. Those extreme fluctuations created severe economic problems for asset-holders, firms and the financial institutions. Even worse, the decline in capital rations in Japan’s banks drove their risk-taking behavior severely. Hanson, Kashyap et al. (2011) pointed out in their research, the generalized asset-shrinking generates two severe macroeconomic phenomenon: credit crunches and fire sales. Thus, the economic stagnation became a continuous process and caused further financial instability. Furthermore, the country was under considerable deflation pressures since 1998, and entered into the vicious cycle, that is, deflation making it harder to repay debts,

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and resulting in further lack of purchasing power and more deflation tendency. During the period, the Consumer Price Index (CPI) dropped by a total of 3 percent, see Figure 4 .

Figure 4 CPI and Real GDP of Japan

Sources: Cabinet Office, “Annual Report on National Accounts”

2) The Implementation of QE policy in Japan between 2001 and 2006

Confronted with such serious economic situation, on March 19, 2001 the Back of Japan introduced a new and unprecedented monetary easing framework. The main idea is, under a zero interest rate, conduct quantitative easing to promote economic activities to form advantageous expectations and resume the effectiveness of monetary policy. The policy consisted mainly the following three pillars:

(i) The operational target for money market operations would be switched from the uncollateralized overnight call rate to the outstanding current account balances (CABs). The target level for CABs was set at 5 trillion yen for the time being.

(ii) The framework is committed and would stay in place until CPI registers stably at zero percent or increase stably.

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(iii) The amount of outright purchase of the Japanese government bonds (JGBs), would be raised if necessary, up to a ceiling of the outstanding balance of banknotes issued. The timeline of the main steps of the policy are summarized in Table 1.

Table 1

Date Activities Expectations

1999/2/12 (Introduction of ZLB)

Introduction of zero interest rate policy To stimulate

economic activities. 2001/3/19(Introduction of

QE)

Introduction of new monetary framework Prevent continuously

declining prices and promote economic growth

2001/8/14 Raise CABs target to 6 trillion (yen) To support economic

recovery

2001/9/18 Introduction of JGBs, reduce discount rate to 0.1 percent To secure proper

functioning of financial markets and enhance the effectiveness of monetary easing policy.

2001/12/19 Raise CABs to target 10-15 trillion (yen) To secure the stability

of financial market and support economic recovery.

2002/2/28 Increase JGBs to 1 trillion (yen) per month To further secure

financial market stability. 2002/10/30 Raise CABs target to 17.22 trillion (yen); Increase JGBs to 1.2 trillion (yen)

per month

To maintain the smooth functioning and stability of financial markets.

2002/12/17 Accept asset-backed commercial paper as eligible for collateral etc. To secure smooth

corporate financing

2003/5/20 Raise CABs target to 27.30 trillion (yen) To make sure the

financial market stability

2003/6/11 Introduction of purchases of asset-backed securities (ABSs) To strengthen the

effectiveness of the transmission mechanism

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203/10/10 Raise CABs target to 27-32 trillion (yen) (6 months to 1 year) To promote economic

recovery.

2004/1/20 Raise CABs target to 20-35 trillion (yen) To reaffirm the policy

stance fighting deflation

2004/4/9 Introduction of government securities lending facility To enhance liquidity

and maintain the smooth functioning of government securities markets

2005/5/20 Extend the project-period of Outlook for Economic activity and Prices by

one year

2006/3/9 (Exit from QE) Exit of QE policy The transition of

normal economic situation.

Source: Ugai (2006) “Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses)

As Table 1 shows, the CABs’ and JGBs’ targets was raised several times. Conditional on the change of the operational target under the QE framework, CABs held by increased dramatically, from 5 trillion yen in January 2001 to 31.2 trillion yen by March 2006. ( Figure 5), and the increases of JGB purchases resulted in an enormous expansion of assets and liabilities on the BoJ’s balance sheet. By 2006, shortly before the exit of QE policy, the balance sheet of BoJ expanded from 112.3 to 152.6 trillion yen.

Figure 5. JGB target and CAB (target) during QE (03/2001–03/2006)

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The effectiveness of QE program is investigated intensively by previous researchers. Oda and Ueda (2005) found that zero interest rate commitment had a significant impact of lowering medium to long-term interest rates, with the use of a so called macro-finance approach; Kobayashi et al. (2006) concluded that the excess returns on bank stock prices were influenced significantly by increasing CAB target and JGB purchase amount.

3.2 US’s QE Policy application during 2008-2009

1) Background

Prior to the crisis, the asset the U.S. government took over from the two mortgage giants, Fannie Mae and Freddie Mac mounted to more than several trillion dollars. On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman's collapse was the largest in financial history, as its assets far surpassed those of previous bankrupt giants. As the fourth-largest investment bank in U.S., at the time of its collapse, 25,000 lost their jobs worldwide. And, the fifth largest, Merrill Lynch was bought out by Bank of America with fifty billion dollars due to asset deterioration. The largest global insurance group, AIG, also faced crisis and was bailed out by U.S. government with 85 billion dollars. It stock price dropped nearly 95%. And in New York, the Dow Jones Industrial Average closed 504 points down, which is about 4.4 percent. Thus, the devastating financial tsunami broke out and influenced the global economic and financial market. At one point the U.S. Federal Reserve was forced to step in, to mitigate the impact of the Financial Tsunami, the Fed started to implement the policy of Quantitative Easing.

2) QE program launched between 2008 and 2009

On November 25, 2008, the Fed announced a total amount of $100 billion purchase of government-sponsored enterprise (GSE) debt and $500 billion of mortgage-backed securities (MBS). On March 18, 2009, a further additional purchases of $100 billion in GSE debt and $750 billion in MBS was announced. The time line is summarized in Figure 5.

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Figure 5 Timeline of Fed’s announcements between 2008 and 2009

Source: Federal Reserve Back of St. Louis Review, January/February 2013

The Fed’s QE program applied between November 2008 and March 2009, commonly refers as “QE1”, were designed to promote economy recovery, especially in housing credit markets, which was hit seriously by the sharp fall in real estate prices during 2006-2008, the more than 80 percent of the assets purchased, named GSE debt and MBS were directly contributing the housing market credit. The purchases substantially raised excess bank reserves and lowered the long-term real interest rates via the impact on term premium, according to Gagnon et al.

3.3 Comparison of QE policy in Japan and the USA.

1) Similarities

Before the crises, both countries experienced high growth rate and low inflation rate. The start of 21 century in the U.S. and 80s in Japan, they both experienced rapid growth and low inflation. With the expectation that low interest rate will remain, financial institutions underestimate the potential risks. Moreover, financial leverages had been intensively used swo that price of asset skyrocketed to form bubbles. The financial institutions as a whole beared great risks that when they realized the exposure, they started to implement tight policy, making market flow stagnant, and the financial crisis broke.

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Both countries did not realize the bubbles burst at the moment, leading to severe impact. In 1989, Japan’s stock market had come to its highest and land price index also reached the highest point. At the beginning, Japanese banks did not realize how severe it was and looked of it as normal economic cycle. Japan started to implement loose monetary policy in 1991. The U.S. is no exception. Growth rate of housing investment became under zero in first season of 2006. Fed did not lower the interest rate until 2007. The market suspected that it will ignite the economic bubble again. Market sentiment is that decreased interest rate by Fed can lead to rising price of international materials. The significance of the policy is unsure before and after the crisis.

Both crises could be traced back to insufficient flow of financial institutions. Japan’s financial crisis was caused by default of loan market, leading to flow stagnation of short-term financial market. This disseminated to the entire financial market instantly. The subprime mortgage crisis is also due to the bankruptcy of Lehman Brothers, tightening flow of financial market and impacting the international financial market.

Both countries did not improve the financial systems and flew in funds needed to problematic institutions. In mid 1990s, Japan once flew funds to problematic small-medium banks and financial institution for housing, triggering society’s disagreement. Therefore, the fund for large banks that easily cause systematic crisis was delayed to later 1990s. During the time, financial departments defunction and distressed debt together worsened the recession, expanding the problem of distressed debt. In mid Sep., 2008, Lehman Brothers and AIG’s financial status aggravated. U.S. government declined to provide financial support to Lehman Brother for reason of wasting tax, but it provided financial support to AIG two days later. This move confused the population on U.S. government’s direction and principle, increasing the uncertainty among the population making the financial crisis worse.

2) Differences

Firstly, the backgrounds of the two countries are different before the introduction of QE. The magnitude of bubbles is smaller in the U.S. than in Japan. The cause of both bubbles is banks lacking sense of risk and over-financing; when the credit marketing was expanding, and marketability is in surplus, the price of housing and land asset can become bubble. U.S. is the debtor. After financial institutions secured mortgage, most of the products are held by international

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investors. The risks can also spread to the world easily that the influence can be complicated. Therefore, every country and central bank has to figure out right policies to mitigate the crisis. Japan is the creditor so that problems of distressed debt are subject to domestic market. The consuming patterns and financial development are different. Japanese banks’ zero interest rate considered mainly to direct enterprise loan to low interest rate by its interest rate policy, stimulating investment and the economy. But, Japan ignored the fact that in the society, the saving rate was high and in elderly society, retirees are dependent on the saving rate. At the time, Japan’s financial tools were not yet developed that private funds can only switch from short-day deposit to long-day deposit; thus, the financial market was not efficiently functioning, and the zero interest rate was unable to bring expected results. As for the U.S., saving rate was low that most people consume by credit. Americans are used to use before they pay. Fed now has directed the interest rate to near zero, expecting that the money multiply effect can come into full play. Moreover, various financial tools in the U.S. are options population can opt for.

Due to different background of the crises in Japan and the U.S., the policies taken are also different. Both the subprime mortgage crisis and Japan’s economic bubble were caused by banks lacking sense of risk and over-financing, leading to flowing supply surplus that cause the bubble burst. But, the difference lies in that in the U.S., distressed debt is mainly asset backed products. This would cause the defunct ion of capital market. Whereas, in Japan, distressed debt was made with business land loan, leading to defunct ion of banking. Further, the crisis magnitude in Japan is greater than that in the U.S. Moreover, U.S. is debtor in the crisis; risk will spread to the world easily, but Japan is creditor, the impact in confined to domestic market. Last, the consuming style and the extents of financial development in two countries are different, influencing the countries’ decision.

Although the fundamental structure of Fed’s policy facing the crisis and Japan’s quantitative easing policy are similar, the focus of two countries’ policy is different because U.S.’s main financial association focuses more on capital market, but Japan focused on banking sector. Fed’s policy focused on asset, concentrating on risky asset’s credit easing in hope that improvement of credit market can decrease credit amount. Japan central bank’s policy of zero interest rate and

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quantitative easing focused on debt operation to expand base of currency so that banks can make more loan and increase the amount of currency.

Because the American financial market is mature and the Fed also applies loose credit policy actively and flexibly, credit markets started restore. Enterprises can finance more efficiently, making future economy restoration much faster. Comparing to Japan’s zero interest rate and quantitative easing policy, the policy concentrated on expanding banks’ excess reserve, diminishing the uncertainty of flow among financial association and exerting the influence of fiscal system and loose monetary policy. Although the aggravation of Japan’s economy stopped, the banking industry was still confined to tremendous distressed debts, credit extension recessed. Adding to that, interest rate is near zero that people would rather holding money than deposit, leading to decrease of money multiplier. Money supply is thus still in shortage, deflation remained.

3.4 Critiques of QE policy

As showed in previous section, QE policy played a significant role in preventing the economy to further recession and effectively maintained the stability of financial markets. However, QE policy is also considered to have several drawbacks. Firstly, Execution of QE only buys more time but not solve the underlying economic problems. The pressure on central banks to create higher economic growth is only temporally alleviated since interest rates are already very low, and the nearly-zero-interest policy is also one of the consequences of the situation, but real effective solutions are still urged in longer time. Secondly, Quantitative easing has an upward effect on commodity prices, as the countries that conduct QE policies, for example in Japan and in U.S., they both show the tendency to inhibit growth because of import growth. Furthermore with the promising low interest rate over period, the investors are likely to step into even more riskier investments. That could cause an enormous blow in a subsequent recession. And though money are injected into the market directly, whether QE can stimulate the economic growth as expected remains controversial. In such situation when the interest rates are abnormally low and the assets’ prices are temporarily lifted by QE policy, the asset holders would anticipate that the prices would fall back when economy is back to normal and QE policy is reversed. They would begin selling bonds, and they would lose more value as the higher inflation expectations. As a consequence, it

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becomes increasingly expensive for both the government and the private sector to refinance debts, and risks of bankruptcy loom.

4. Conclusion

To deal with the severe situation after the financial crisis of 2007-2008, the Federal Reserve conducted a policy of large scale of asset-purchasing, known as Quantitative Easing policy, which aimed to stabilize the financial system and limit the damages from the crisis. However, the first QE policy experiment, can be traced to the Bank of Japan in 2001, after its decades of deflation and stagnant economic growth. In this paper, by comparing the first two rounds of QE in Japan and in the U.S., we have found that the effectiveness of Japan’s QE program took longer than the U.S.’s, due to the its damaged economy in which the policy had been made and the frail status of the banking sector. While the QE in U.S., addressed its aid more towards the banking industry. Despite those differences, in both countries, QE played a significant role in supporting economic activities, and prevent further financial collapse.

Since the end of 2009, the Eurozone debt crisis obliged more leading central banks to pursue such aggressive monetary actions. Thus studying of the effectiveness of QE policy and investigating its long-term impacts on economic growth, become crucial for deciding its viability to spread worldwide. But according to the previous studies, the magnitude of QE policy’s effect on economy is difficult to calculate and its direct link to economic growth remains controversial. And furthermore because there is nothing to prevent the central bank from breaking the QE commitment in the further when economy starts to recover, QE has the tendency to be ineffective in long term. Therefore, the optimal monetary policies under extraordinary circumstance and for longer term, is still an ongoing study and no concrete solutions generally accepted so far. But with the increasing use of QE worldwide, especially the more recent evidences from the Eurozone, we have no doubt about the continual innovation and perfection of the monetary policy in future.

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The unconventional Monetary Policy at Zero Lower Bound : an empirical analysis of “Quantitative Easing” in Japan and US