The quantitative easing policies of Japan and the United Kingdom compared : a literature study

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The quantitative easing policies of Japan and

the United Kingdom compared

-a literature

study-Faculty of Economics and Business Bachelor Thesis

Abstract

This paper tries to find the similarities and the differences in how Japan and the

United Kingdom execute quantitative easing (QE) and how it influenced the

economy. In this paper . While both countries reached their targets of improving the

consumer price index (CPI) during the period of quantitative easing it is still

debatable whether or not QE is responsible for this effect. I found that Japan was

strong in the commitment to QE and the United Kingdom managed to let investors

rebalance their portfolios. For the United Kingdom a decrease in gilt yields is

apparent while the Japanese governmental bonds remained unaffected.

Bram Prins 10675132

In the hands of Rutger Teulings January 31, 2017, Amsterdam

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Statement of Originality

This document is written by Bram Prins, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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1. Introduction

In recent years many central banks engaged in large scale asset purchases(LSAPs), mostly known as quantitative easing (QE), however their results differ. The first central bank was the Bank of Japan, who started using QE in 2001 and used QE multiple times afterwards. Just after the economic crisis in 2008 the Bank of England started with quantitative easing, followed by the Fed in 2011 and finally the European Central Bank (ECB) started with quantitative easing in 2015 as well. Even though many research has been done in the subject of QE, the policy of the ECB was too recent to be investigated thoroughly at this time. Furthermore the factors of what would make QE work for some central banks and not work for others are not fully known and there is no consensus between economists. This thesis tries to diminish this gap by examining the differences in the execution and the results for the first two countries, Japan and the United Kingdom, that started with QE. These two countries have central banks with similar goals resulting in a comparison between their results due to QE becoming more relevant. Furthermore, both their QE policies were sufficiently in the past that former research is done and it provides enough data to be able to thoroughly examine the policies and results.

Previous research did investigate how the economies of Japan and the United Kingdom were impacted by QE. The effect on bond yields, the CPI and GDP has thoroughly been investigated. These studies have indicated that QE indeed used some of the theoretical channels, the channels are the mechanisms in which QE affects financial and economic variables, however a comparison between the two countries based on the channels has not been made.

The aim of this paper is to compare the policies and their effects by making use of the different channels of QE. By examining the channels and their effects the practice of the central banks will be examined by not only their results, but also by the economic theory which further explains the possible strengths and weaknesses of QE.

The structure of the remainder of the paper will be as follows. First, in section two I will discuss the role of central banks. They have control over specific variables and have certain tools, their conventional monetary tools will be explained in this section. Next section three will introduce the unconventional monetary policy i.e. QE. The reason why conventional monetary policy might not be sufficient and why unconventional monetary policy might work is discussed in this section. Then in section four the policies of the QE of Japan and the United Kingdom will be discussed and their results will be examined by using the affected channels. In section five I will discuss the similarities and differences between the two countries. Finally in section six I will conclude the findings and the work will be summarized.

2. Role of central banks

This chapter will explain the role of central banks within the economy and their conventional tools will be discussed. According to Mishkin central banks are responsible for monetary policy (Mishkin, 2004). According to him central banks do not have anything to say about fiscal policy, which is done by the government, that covers the laws and execution of taxation and government spending. Monetary policy however fundamentally covers the supply of money into the economy. This means that the central bank has the decision over the amount of money that is being printed and brought into the economy. Alesina and Summers explain that a more independent central bank is one that has more power over this monetary policy without the government interfering (Alesina & Summers, 1993). The theory in above mentioned article states that a central bank which is more independent might be more predictable with their actions, causing less risk premia. All actions will economically

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5 make sense as central bankers are then able to asses a longer term economic view than politicians would have as politicians will often be concerned with elections and would deviate from the best decisions.

2.1 Goals of central banks

To influence the economy central banks can have multiple goals they target their monetary policy at. This section will explain the different goals central banks can have to understand what economic parameters quantitative easing should affect when we consider different central banks.

First of all, maintaining a low or stable inflation could be the goal of a central bank. This is for example what the ECB has committed itself to, their statement about their goal is that it is “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.” (ECB, 2017). According to Bernd in Europe the reason for this goal is for one reason the choice of the public (Bernd, 1998). It is explained that Europeans and especially German people, as they have experience with extremely high inflation, are more likely to be inflation adverse and thus will support a central bank that is inflation adverse. The article states that the German central bank which preceded the ECB was also inflation adverse and also very independent. For the central banks there are multiple reasons why they might choose for price stability as a goal, first of all price stability will make sure relative prices of goods are easily compared, consumers can see that these prices change without being distorted by the overall price level (Mishkin, 2004). Secondly Mishkin explains that when the prices are stable the consumers will not have a disruption in their spending, with extremely high inflation there would be nearly no saving as prices tomorrow would be too high, with deflation there wouldn’t be any current spending as prices tomorrow will be lower, so saving the money is beneficial. The European Central Bank adds that the price stability is also beneficial for the financial markets as there is no extra risk associated with a higher price volatility, thus hedging to get stable prices is not necessary either and together this will increase the incentive to invest in the areas with stable prices (ECB, 2017). Apart from that the ECB states that maintaining a low inflation will not distort the redistribution of wealth and will ensure no distortions in the tax and social security systems. It is argued by Alesina and

Summers(1993) that a more independent central bank would be more adverse to inflation and that a lower inflation would result in a better economic performance, multiple recessions in the United States are claimed to be caused by letting the inflation increase too much. However on the other hand the same theory states that central bankers might be more inflation adverse and thus turn too much against preventing inflation, in that case a more independent central bank could also be lowering economic performance as there might be a trade-off between inflation and other measures of economic performance.

A second goal central banks might have is to ensure a low unemployment rate (Mishkin, 2004). Again this is a reason with the general public in mind as the general public has the wish to be employed. This is not only political as the monetary system and the economy thrive when the unemployment is limited. Less unemployment will mean less costs for social security and more possible consumer spending and thus a higher GDP and stronger overall economy (Mishkin, 2004).

A third possible goal central banks could have is the goal of increasing the GDP, for example the Bank of England (BoE) has this goal (Lyonnet & Werner, 2012). GDP is a frequently used way to test how well a country is economically performing, or more specifically what is being earned in the country (Mishkin, 2004). When the GDP increases it means the country is getting richer, when it increases relatively faster than for other countries the country becomes more competitive on the market.

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2.2 conventional monetary policy

A central bank has multiple ways to reach their three possible goals, this chapter will be explaining their conventional monetary policy which can be seen as their original ways of executing the monetary policy they have determined.

2.2.1 Open market operations

The first option a central bank has is to do an open market operation (OMO) (Mishkin, 2004). In practice this means that the central bank will purchase or sell assets, mainly securities of the government, which banks have in stock and in exchange pay or receive money. What this will do is this will either increase or decrease the supply of money into the economy and thus the monetary base and the reserves banks have will become higher or lower. In case of a purchase of assets, a monetary expansion, the monetary base and reserves of the bank increase and thus the interest rate decreases as money becomes less scarce, banks are more willing to lend money to other banks, called interbank lending, and thus ask a lower interest in return. In contrast when there is a

monetary contraction the central bank is selling assets, the monetary base and reserves will decrease and the interest rate will increase because of the scarcity of money (Mishkin, 2004).

2.2.2 Lender of last resort

Secondly a central bank has the tool of standing facilities to its disposal, what this means is the central bank in question is the so called “lender of last resort” (De Grauwe, 2013). When a commercial bank needs liquidity the fastest way they can regain money is through borrowing it from another bank, the rate that banks charge each other is called the overnight interbank interest rate (Bernanke & Reinhart, 2004). However there is the possibility that banks do not want to lend to or borrow from each other, if this is the case central banks are able to offer this liquidity to prevent any bank panics. The central bank can set the rates for which the commercial banks are allowed to borrow, also the central bank can set the rates for which the commercial banks can deposit their money. The ECB is especially known for using these rates as the ECB uses the overnight bank rate as another tool, banks are allowed to deposit their money for the deposit rate and they can borrow money for the lending rate. This way the overnight interbank rate, which is the rate at which banks lend to and borrow from each other, will always be the same as or lower than the lending rate and the same as or higher than the deposit rate.

2.3 Monetary transmission channels

According to economic theory there are multiple channels through which monetary policy will influence the economy. This paragraph will explain those channels. It is worth noting that the explanation focus on the case where there is a monetary expansion, in case of a monetary contraction all effects will work in the opposite direction.

The first monetary transmission channel is the interest rate channel, this channel is based on the traditional IS-LM model, which is developed by John Hicks (Hicks, 1937). According to Pilbeam (2013) this channel is one which central banks use a lot, it tells us how the interest rate will affect the consumer spending and the economic growth. When the central bank uses a monetary expansion

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7 the monetary base will rise, the interest rate will decrease and this will lead to an increase in the investments and spending of consumers and companies. This channel, although following an simple economic intuition, is important to central banks. If central banks use this channel it is a way to increase the economic growth, the higher investment and spending lead to a higher demand for money and the interest rate will increase again reaching a new economic stability. This channel thus is the base for the OMOs, when a central bank executes an OMO in essence they are using this channel to target the interest rate and that way influence the economy.

The second monetary transmission channel is the credit channel, this channel consists of the bank-lending channel and the balance-sheet channel (Bernanke & Gertler, 1995). The bank-lending channel explains that when there is a monetary expansion, apart from the lower interest and thus lower price of money, commercial banks simply have more money on their balance sheets and thus are able to provide more loans. Loans provide banks with a higher return than securities do, the net worth of a bank is determined not only by the amount of money it has, but also by the amount of future cash flows. The balance-sheet channel explains that when banks have more money on their balance sheet because of the monetary expansion the result of replacing securities with loan thus will increase the bank’s net worth.

The third channel of monetary transmission is the exchange rate channel, which explains effects of the exchange rate after monetary policy (Svensson, 2000). In case of a monetary expansion the interest of the home country decreases, it is thus less attractive to invest money at home

because of the relatively lower interest rates and more attractive to invest it in the foreign country because of the relatively higher interest rates. Because of this the home currency will depreciate against the foreign currency because the demand to exchange the home currency to the foreign currency increases. As the home currency is relatively cheaper it is relatively cheaper for the foreign country to import from the home country and thus the export of the home country will increase. When the export increases the economic growth of a country increases as well (Leitemo & Sóderstróm, 2005).

3. Unconventional monetary policy: Quantitative easing

The following chapter will cover unconventional monetary policy. Here I will be looking at what quantitative easing is, what it’s characteristics are and why a central bank might choose to execute it.

Unconventional monetary policy is extremely broad as all policies a central bank can image that are not classified as conventional monetary policy would be classified as unconventional

monetary policy. However central banks only control monetary policy so they are not able to deviate from agreements, laws and legislation. Furthermore central banks will have no gains by making any uninformed decisions, they thus won’t simply do something for the sake of it being unconventional. This paper will only be focussing on QE as unconventional monetary policy as all other possible unconventional policies are irrelevant for this research.

3.1 Limits of conventional monetary policy

Conventional monetary policy only has limited powers, in case of an economic crisis it might not suffice to get the economy back to a desired stability level (Joyce, Miles, Scott, & Vayanos, 2012). In such a case the financial system could be disrupted, the monetary transmission mechanisms don’t work as they are expected to. In this case banks’ loans might not be able to be paid back and their

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8 demand for reserves increases, then when there is less trust in the economy credit holders will want to receive their money back. In times of a crisis the interest rates will often reach zero percent (Goodfriend, 2000), this is called the zero lower bound. When the interest rates are at zero percent they cannot be lowered any further with the same effect. A lower interest rate would be negative and that will not stimulate the economy because instead of lending and investing investors will tend to keep their money as they will have to pay back less than they borrowed. Fisher (1933) explains this phenomenon as the liquidity trap.

In a case as described in the former paragraph the central bank will need unconventional tools to mitigate the liquidity trap. In a normal OMO the central bank will purchase securities with their reserves, in case of QE the central bank is purchasing assets as well, however with some important differences. First of all QE has a higher magnitude, a regular OMO barely affects the balance sheet of the central bank, while QE might multiply the balance sheet. Furthermore OMOs are used for the short term of around a couple of months, mostly short term securities are purchased, QE on the other hand is used for multiple years and all kinds of assets are being purchased, short- and long-termed securities, but also private assets can be purchased in the case of QE. In other words, the central bank will be printing money to increase their balance sheet and purchase

securities from that, the idea is that when enough new reserves are created the economy will be able to relax again and there will be more spending and investments. The main differences between a regular OMO and QE can be seen as a different way of targeting, an OMO targets the interest to influence the economy while QE targets the quantity of reserves to influence the economy.

3.2 Channels of quantitative easing

Just like conventional tools of monetary policy QE has multiple channels through which it affects the economy. First of all, for the central bank to commit to printing extra money when there is a need for extra reserves they can provide a signal to the market. The market receives this signal and the expectations for the future might be influenced. If the market knows what the central bank will do it will act accordingly, when it knows the central bank will be providing liquidity the fear of becoming illiquid will decrease and the market will increase their investments(Borio & Disyatat, 2010).

Second, there is a commitment channel. This channel depends on the strength of the

commitment of the central bank in question. Through this channel the central bank enforces their goal of the monetary policy by continuing QE until their targets are met. In practice this means that at a certain moment the economy would tend to grow and the demand for money increases this much that the interest rates would go up. The central bank can then keep the rates low until the goal of the QE is met to influence the economy on the longer term and reach a stable growth path (Borio & Disyatat, 2010).

Third, there is a fiscal channel. As the central bank is purchasing securities there is more demand for those government bonds, this results in cheaper financing costs for the government in question. As financing becomes cheaper the government can decrease taxes. So the tax burden for consumers is lower and they will purchase more causing more economic growth (Auerbach & Obstfeld, 2005).

The fourth channel is the portfolio rebalancing channel. When the central bank purchases securities private investors will see the prices of these securities increase. This leads to the private investors purchasing less of these securities and having more money. As having money when there is a low interest rate is not beneficial these private investors will be looking for other investments that will increase their yield. Thus investments will be increasing which will lead to less unemployment and more spending. Because the investments increase the demand for loans increases and the interest increases as well (Borio & Disyatat, 2010).

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9 Furthermore, Vayanos and Vila (2009) introduce a duration risk channel. They explain that the extra liquidity that QE provides will lead to an easier way of financing longer term investments. This provides investors with less risk when investing in longer termed investments. When the risk of these investments decreases the demand to invest will increase and the yield will decrease. The duration risk channel thus implies that the yield of longer termed investments will decrease more than the yield of shorter termed investments.

Another channel of QE is the bank funding channel, which is introduced by Disyatat (2011). This channel explains that when the central bank is providing liquidity weaker banks are more able to refinance themselves. In a situation without QE weaker banks do not often have the possibility to grant many loans, however when they can access more liquidity it is possible for those banks to build more reserves. If the reserves of the banks increase they are also more able to provide loans. When banks have more reserves they are less prone to insolvency and in the case that more loans can be provided there are more investments and the economy can grow.

4. Quantitative easing in practice in Japan and the United Kingdom

In the following chapter the process of quantitative easing in Japan and the United Kingdom will be investigated. This chapter will start with covering the situation in Japan simply because the

quantitative easing preceded the one in the United Kingdom.

4.1. Japanese Quantitative Easing Policy

The economy of Japan suffered from stagnation since the asset price bubble in the early 1990s (Ugai, 2007), from this moment the growth rate of the consumer price index (CPI) became smaller, this was followed by a decline in the CPI from 1998 until 2005, in this period the CPI shrunk with three percent (Oda & Ueda, 2007). When the IT-Bubble burst in the end of the 90’s the

economy of Japan was heading towards a recession, there was a risk of deflation and the interest rate was near the zero lower bound, so the Bank of Japan (BoJ) needed to react with an

unconventional monetary policy. The policy they decided on was called the “quantitative easing policy”(QEP), which had the following three goals:

I. To change the target of market operations the BoJ executes from affecting the interest rate to ensuring that commercial banks keep a high amount of reserves in the form of current account balances(CAB) at the BoJ. The CAB basically are bank accounts that commercial banks keep at the BoJ. Furthermore the BoJ commits to provide liquidity to enable the commercial banks to keep these CAB.

II. To make a commitment that the liquidity commitment will be provided until the growth of the CPI is constant at zero percent or it has a year on year increase i.e. the BoJ will provide the liquidity until the CPI is not declining.

III. To increase the purchase of long term Japanese government bonds up to a certain amount of money, but the BoJ is able to raise this target when they find it necessary to do so.

(Ugai, 2007). The Bank of Japan purchased mainly long term government bonds, by doing so in theory the yield curve would flatten, as it flattens long term interest rates will become smaller and it is thus cheaper to invest for the long term. When QE started, the BoJ targeted commercial banks to hold CAB of five trillion Japanese Yen. This target was one trillion yen higher than the required reserve level of four trillion Yen. They then raised the target as time passed, in January 2004 the target was at 30 to 35 trillion Yen. The BoJ increased their purchases of long term Japanese bonds from 400 billion Yen per month at the beginning to 1200 billion yen per month from October 2002. The following graph clearly shows how the Bank of Japan increased the amount of CABs throughout

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10 the time.

Figure 1: amount of CABs resulting from the Japanese QEP. Source Ugai (2007)

Figure 1 shows the magnitude of the QEP, furthermore figure 1 shows that the BoJ had specific target ranges for the amount of CAB, which expanded during the QEP. The BoJ gradually increased the target to make sure the market wouldn’t stress out, during the QEP the BoJ’s reasoning for increasing the target was that the financial markets needed the liquidity injection. Also shown is that after the quantitative easing policy ended that the BoJ stopped with using the CABs as a target and the amount of CABs thus decreased. Last the excess reserves are shown, which together with the required reserves make up the full amount of CABs.

At the end of 2005 the BoJ provided a monetary base of 117 trillion Yen in the form of CAB and money, the monetary base were on the liability site of the balance sheet. As assets on the balance sheet there were the long term bonds they purchased which were worth 63 trillion Yen.

Furthermore, the BoJ purchased asset backed securities, aiming to support this market and

strengthen the monetary transmission channels. The CPI in Japan became positive from November 2005 and in March 2006 it was at 0.5 percent, the BoJ expected the year on year growth in the CPI to remain positive and thus quit the QEP. The BoJ then switched the goal 1 as mentioned above back to keeping the overnight call rate at zero percent and as the QEP was finished thus dropped the two other targets.

Ugai (2007) has investigated exactly how the policy of the BoJ affected different variables and whether it was a clear effect or not. He explains that the BoJ made use of the signalling channel, as explained in chapter three in this paper, they tried to change expectations of different agents by openly committing to purchase more bonds when necessary and printing the money required, however it is impossible to know whether or not this has indeed changed agents’ expectations. Before the QEP the BoJ already kept the interest rates at zero, this policy is called the zero interest rate policy (ZIRP). Ugai explains that the QEP continues with this ZIRP alongside the asset purchases. The main transmission channel of maintaining the QEP until the CPI was stable was to commit to a short term interest rate of zero, the BoJ mainly used the commitment channel of QE.

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11 This commitment channel was intended to let the private sector know that the interest rate of zero would be maintained until the CPI condition is satisfied, even if there would be an economic growth in the meantime. This should stimulate the economy to lower the present short- and medium-termed interest rates. Baba, Nishioka, Oda, Shirakawa, Ueda, and Ugai (2005) have developed a model which estimates the effect of the commitment channel by making use of the yield of Japanese governmental bonds. They capture the channel by calculating the difference between the expected future path of the yield curve with commitment and the expected path of the yield curve without the commitment. The main finding is that the difference between the model with commitment and the one without increased after the second half of 2002 instead of the beginning of the QEP. They explain that this is a delayed effect of the commitment. It is reasoned that the difference is not there when the economy is very pessimistic, but that the difference will be there when there is an

economic recovery, because then there is the possibility that the interest rates will increase because the interest rates are likely to go up as soon as the CPI is reached and the BoJ chooses to stop with the ZIRP. The commitment of continuing with the ZIRP is then considered to be strong as it shows the bank is willing to commit to increase the CPI even though the economic growth could be higher with additional investments because of the higher interest rate. The rate of the 10 year governmental bonds did not have a difference between the models as high as the short- and medium-termed interest rates had, for the short- and medium-termed rates the difference was about 0.4-0.5% and for the 10-year bonds it was about 0.2%, the authors argue that this might be because of the future inflation rate increasing due to a lowering yield curve (Baba, Nakashima, Shigemi, & Ueda, 2006). A similar effect of the commitment is found by Okina and Shiratsuka, who broke down the forward interest rates and use those to estimate the policy duration effects. They found that the policy duration effect strengthened in 2001 when the QEP was adopted and in 2002 during the QEP (Okina & Shiratsuka, 2004).

Apart from the commitment effect there are many studies trying to find whether there is a portfolio balance effect caused by the Japanese QEP. In case the BoJ purchases financial assets that are substitutes for other assets there might be a portfolio rebalancing channel as being explained in chapter three. Oda and Ueda have used a regression analysis to find whether or not the purchase of Japanese government bonds by private investors changed as a result of the BoJ mass purchase of those bonds. They did find that all signs of the bonds should be as expected in a normal economy and thus conclude there is no portfolio-rebalancing in the case of Japanese governmental bonds (Oda & Ueda, 2007).

Apart from investing in Japanese bonds, he BoJ also invested in private equity. To check whether or not a portfolio rebalancing channel was present for these assets Kimura and Small used the capital asset pricing model (CAPM). Kimura and Small did find a significant effect for the private assets, so even though investors did not change their behaviour with respect to the governmental bonds there was a significant difference in investors’ behaviour of purchasing private assets, they expect investors to rebalance such to get counter cyclical returns to the market (Kimura & Small, 2006).

According to Baba et al. the ample liquidity the BoJ provided made sure many banks did keep a high amount of reserves at the BoJ, thus making sure the banks did remain solvable. For the weaker banks this was fortunate as it made sure they would not get into liquidity problems. This led to a situation where it was easier for firms to gain funding and thus weaker firms were able to finance themselves as well. The research also found that credit ratings were not reflected in the economy as all firms were able to get hold of liquidity. (Baba, Nakashima, Shigemi, & Ueda, 2006).

4.2. United Kingdom quantitative easing

After the world-wide economic crisis of 2008 the United Kingdom like all other countries had to recover. The first action executed by the Bank of England (BoE) was to cut the bank rates. They cut it with three percent in 2008 and in March 2009 it was at a half percent, effectively reducing it to the

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12 zero lower bound. However, the BoE concluded that even with the measures taken the CPI would not reach the 2% year on year increase as they wanted it to have, they decided to take additional

measures, so they announced that they would start a large program of purchasing assets using central bank money (Lyonnet & Werner, 2012)The goal of this QE policy was solely to give a monetary injection into the economy and thus reach the two percent inflation target. The

quantitative easing program mostly focussed on the purchase of bonds of the United Kingdom(gilts), although they would purchase private assets as well. Between March 2009 and January 2010 the BoE purchased 200 billion GBP worth of assets, mostly gilts with a medium and long term. These asset purchases covered 14 percent of the GDP and the asset sheet of the BoE three folded compared to the period before the crisis. The BoE was also authorised by the government to purchase private assets to improve the functioning of specific financial markets, those assets include the purchases of high quality commercial paper and bonds issued by companies. Although the scale of the purchases of these private assets was a lot lower it was consistent with the BoE acting as a backstop to improve the market functioning.

The following figure illustrates the amount of gilts being hold by different parties

Figure 2: amount of gilts by different parties. Source (Joyce, Miles, Scott, & Vayanos, 2012)

The purchases of the BoE can clearly be seen, before 2009 the amount of gilts being hold by the BoE was not even really visible in the graph, while when the QE started the BoE purchased many gilts and thus the amount they held increased by a lot.

The bank of England, just like the Bank of Japan, did publicly express their plans to execute quantitative easing. Most of the gilts were being purchased from the non-banking sector, simply because that is the place the gilts were before the quantitative easing, thus the flow of gilts in the economy was being reduced, while the amount of reserves that commercial banks held were being expanded. In case gilts and bank deposits are perfect substitutes in when the interest is near zero there would be no reaction to the yield in gilts when the BoE purchases them, the parties that held the gilts before can simply put their money on the bank accounts and the banks will keep it as reserves. As gilts are often a long term asset and a bank deposit is a short term asset, it might be that investors who sold their gilts will choose to go for another long-term asset instead of putting the money in the bank, thus there would be a portfolio rebalancing effect. If investors do indeed change

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13 their equity holdings then the risk premium of all long term assets does decrease, as there is more funding for long term assets and this will also result in a higher price of those assets. This is already a clear way to see whether or not the portfolio rebalancing effect can be expected. Furthermore, when there are more investments in riskier assets then that means that households will have more money to spend and the GDP will increase as well. There is evidence that assets which investors might have chosen to rebalance their portfolios with have risen in price during quantitative easing, so there is proof of portfolio rebalancing. In 2009 right after the purchases were made the yields on corporate bonds declined substantially, so right after the quantitative easing started the funding became easier for companies. (Joyce, Miles, Scott, & Vayanos, 2012).

For the United Kingdom many macroeconomic variables are hard to quantify during the period of quantitative easing, the reason for this is because the economic crisis was going on and it thus is hard to assess whether or not something came from quantitative easing, or it was the

economic environment. However there had been research to see what the effects of the quantitative easing is while trying to eliminate the disruption from the Economic crisis. It can be analysed that a negative yield shock will lead to a rise in the GDP and the CPI, but it will not affect the policy rates. It has been found that a shock in the gilt yield of ten-year gilts by 100 basis points, resulted in that the GDP is impacted by just under 1,5% and the CPI by about three quarters of a percent (Joyce, Tong, & Woods, 2011). Bridges and Thomas (2011) made this quantification as well by using a multiple time-series approach. The results were that without QE the five and ten year gilt yields would have been 100 basis points higher. When the time-series models are being averaged the GDP had a peak effect of around one and a half percent and the CPI inflation of one and a quarter percent. As the estimates vary a lot between the different models the results are however subject to uncertainty (Bridges & Thomas, 2011).

Lyonnet and Werner tested whether or not the Bank rate, Reserves, Asset purchases, Balance sheet composition, Money supply and bank lending had an effect on the GDP. In case the variables are not joined significant the QE is not effective for this goal. They did find some different results as the theory would suggest and the researches in the former paragraph. In their study it is found that the interest rate and the GDP are positively correlated, a lower interest because of the QE thus also results in a lower growth of the GDP. According to Lyonnet and Werner, asset purchases are quite common for central banks, so the quantitative easing, even though being unconventional because of printing money, does not substantially change the economy compared to regular monetary policy (Lyonnet & Werner, 2011).

5. Differences between Japan and the United Kingdom

The former chapter explained how Japan and the United Kingdom executed quantitative easing and through which theoretical channels there was and was no proof of effect on the economy. The following chapter will discuss what the similarities and the differences between the two policies are.

One of the most important differences is the way of targeting the result of QE. The Bank of Japan set whole new goals before executing the quantitative easing policy. They stopped targeting the overnight bank rate, but instead started targeting the amount of current account balances which the commercial banks had outstanding at the Bank of Japan. Apart from that the Bank of Japan set a clear commitment to the level of the consumer price index, it was clear for all parties in the economy that the Bank of Japan would continue to provide liquidity and maintain a low interest even though deviating from the policy in the short term might have been beneficial for the GDP. This resulted in a clear commitment effect which was not present in the case of the United Kingdom. On the other hand, a significant decrease in yields of Japanese governmental bonds has not been found. In the case of The United Kingdom multiple studies did find a decrease in the yield of gilts, portfolio rebalancing did happen in the case of the United Kingdom, where in the case of Japan there is no clear evidence that investors changed their behaviour with regards to the Japanese governmental

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14 bonds, however as investors did start to purchase more private assets there is a rebalancing effect present, investors tried to seek counter-cyclical returns as opposed to the market.

In the case of both countries the quantitative easing was designed to create a more stable inflation, in the case of Japan it was designed to target the CPI as a result of an internal economic downturn, while the United Kingdom designed it to target the CPI as a result of the world-wide economic crisis. For both countries the effectiveness of the policy is under discussion, in the case of Japan the policy might have mainly helped the weaker banks and companies to get liquidity. The credit ratings in Japan were not reflecting the actual firm quality during QE, so weaker companies could easily finance themselves while they might not have been able to in the economy where the BoJ does not provide the liquidity. In the United Kingdom it can be disputed that the effect of quantitative easing was above the effect conventional monetary policy would have provided, as the country was recovering from an economic crisis it is uncertain if the economy was influenced by QE or by other factors. Following are four graphs which describe the GDP and the CPI in Japan and the United Kingdom before, during and after the QE

Figure 3: Japan change in GDP data provided by WorldBank

Figure 4: Japan change in CPI data provided by WorldBank

3.500.000.000.000,00 4.000.000.000.000,00 4.500.000.000.000,00 5.000.000.000.000,00 5.500.000.000.000,00 6.000.000.000.000,00 G DP in $ Year

GDP Japan

-1,5 -1 -0,5 0 0,5 1 1,5 2 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 CPI Years

Japan CPI

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Figure 5: United Kingdom change in GDP data provided by WorldBank

Figure 6: United Kingdom change in CPI data provided by WorldBank

For Japan a clear effect of the QE can be seen especially in Figure 4. In the period from 1998 until 2002 the CPI was declining. Then the BoJ did introduce QE and the graph shows the CPI reacted and rose during the period of QE, the CPI became positive from 2005, in the second quarter of 2006 the BoJ found this CPI to be stable and thus dropped the QE. The channels of QE can be used to explain how the GDP was influenced. The GDP was falling until the start of QE in 2002, then the BoJ provided extra liquidity so commercial banks and firms were able to finance themselves with reserves and the result is that the GDP can be seen rising until 2004 where the CPI was 0. Then from 2004 the clear commitment of the BoJ can be seen, the BoJ kept the interest rate at zero percent and the yield of investments was insufficient to keep investing so the GDP fell again. Once the CPI reached stable levels the BoJ dropped the commitment and the GDP started to grow again.

In case of the United Kingdom the effect of QE is shown by Figure 5, the GDP was falling from 2007 and when the Economic crisis occurred in 2008 it decreased faster. The BoE started with QE in early 2009 and from that moment on the GDP did in fact increase. For the United Kingdom the main channel of QE was the portfolio rebalancing channel, instead of gilts investors were investing more in private assets resulting in the possibility for firms to expand, the increase of the GDP can thus be explained by this increase in investments in private assets. Empirically as opposed to Japan no strong

2.200.000.000.000,00 2.300.000.000.000,00 2.400.000.000.000,00 2.500.000.000.000,00 2.600.000.000.000,00 2.700.000.000.000,00 2.800.000.000.000,00 2.900.000.000.000,00 3.000.000.000.000,00 3.100.000.000.000,00 3.200.000.000.000,00 2007 2008 2009 2010 2011 2012 2013 2014 2015 G DP in $ Year

GDP United Kingdom

0 0,5 1 1,5 2 2,5 3 3,5 4 4,5 5 2007 2008 2009 2010 2011 2012 2013 2014 2015 CPI Year

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16 commitment channel was found as a result of the actions of the BoE, this can be seen in the graph as well by the fact that the growth of the GDP was not halted at the moment the commitment stopped the economy from developing which was the case in Japan in 2005. In figure 6 it can be seen that the CPI in the United Kingdom was increasing from 2009 when QE started until 2011. After 2011 it decreased a bit again, but was well above threshold in 2015 when the BoE dropped the QE.

The figures show multiple years after QE already ended, it can be seen that the CPI of both countries did in fact decrease in the years after QE. In the case of Japan the CPI became negative in late 2008 and for the United Kingdom it reached 0.1% in 2015. Both central banks recognise this and did start QE again to let the CPI reach their targets.

6. Concluding remarks

In the current economy the fiscal policy of countries are managed by central banks. These central banks can have multiple goals they use to decide upon which policies to execute, these goals include to maintain stable prices, to suppress the unemployment rate and to have a growth in the GDP. Central banks have long been using a set of tools which are being called the conventional tools of monetary policy, with these tools they are able to control different economic variables trough being a lender of last resort for commercial banks, being able to set different rates to let the amounts of reserves increase or decrease and use open market operations to control the supply of money.

The conventional tools of a central bank might not be effective anymore when the economy is in a liquidity trap. When the zero lower bound is reached the central bank is not able to target the interest rate anymore to influence the economy, in those cases unconventional monetary policy can be an option. In 2002 Japan was the first country to introduce a new sort of unconventional

monetary policy, namely QE. QE can be defined as the purchase of assets by providing new liquidity, so in essence printing new money to purchase thus said assets. This differs from a regular OMO in multiple ways, first of all the scale of the asset purchases is a lot bigger. Second, the duration of the policy is longer, while an OMO lasts for a couple of months, QE can last for multiple years. Third, while during an OMO the central bank only purchases government securities, during QE private assets can be purchased as well. The idea is that when these assets are purchased the economy will be boosted because of the low interest rate and the investors moving away from governmental bonds and investing through other sources, the ways that quantitative easing affects the economy are being called the transmission channels of quantitative easing.

As being mentioned before Japan was the first country to start with quantitative easing, Japan had a year on year deflation and the economy did not grow, the Bank of Japan thus needed additional measures to ensure the economy would be growing again. The Bank of Japan decided on a large asset purchase program with as a target to make sure the current account balances that

commercial banks kept at the Bank of Japan would increase, this to make sure there would be a stable CPI, preferably with a year-on-year increase. The Bank of Japan showed a lot of commitment using this policy, investors were clearly aware that the interest rate would stay low until the CPI did in fact increase. Even though there was no clear decrease or portfolio rebalancing in case of the Japanese government bonds there was portfolio rebalancing in the corporate bonds. Apart from that the quantitative easing policy ensured enough liquidity was available for the weaker banks.

When the world-wide economic crisis hit the United Kingdom had to recover. The Bank of England decided that the conventional tools would not be enough to ensure a quick recovery and thus decided on an asset purchase program. The Bank of England greatly increased their balance sheet by purchasing a large amount of gilts, to try and get the CPI on a stable path again. The Bank of England managed to cut the yields of the gilts back and in the economy rebalancing was present.

Where Japan profited from the commitment channel, the UK profited from the rebalancing channel. Both countries benefited during the period of quantitative easing, however the results are

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17 not uncriticised. In the case of Japan mainly weaker banks and firms did profit from the provided liquidity, the QE thus can be seen as a way to help them. When the United Kingdom started QE the CPI was not unstable, because the BoE started QE right after the economic crisis it is hard to assess what effects were due to QE and what effects were due to the economic climate.

Both countries did have some economic downturn a while after the QE was over and both have been executing QE again, research is necessary to assess if the past has changed the way they currently execute QE. Apart from that this study had mostly been focussing on the Macroeconomic and partly on the financial site of the process. The fiscal effects were not thoroughly studied, while in both countries the theory suggests a fiscal transmission channel might be possible, also the growth of the GDP and CPI have been covered as this is something both central bank’s target, when a central bank targets the unemployment rate like the Federal Reserve of the United States does the results and methodology might be all different.

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The quantitative easing policies of Japan and the United Kingdom compared : a literature study