Quantitative Easing - A lesson learned from Japan

On November 3rd, 2010, Federal Reserve Chairman Ben Bernanke announced that the Fed was undertaking a program of Quantitative Easing (QE) known to some as QE2.  This program will purchase about $75 billion worth of United States Treasury long-term debt on a monthly basis through June 2011 for a total "investment" of $600 billion.  This is a last gasp, desperate, eleventh hour measure to stimulate the moribund United States economy which has not responded to an earlier round of QE and near zero interest rates.  By purchasing United States debt, the Fed is hoping to prevent the much dreaded spectre of deflation and stimulate banks to increase loans by pumping billions into the economy.  The Fed also announced that it would reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier $1.25 trillion investment in a portfolio of United States mortgage debt.  At the same time, the Fed announced that it would continue its policy of near zero interest rates for an "extended period".  To put the $600 billion number into perspective, this is about 4 percent of the United States economy annual output.

QE is basically the last bullet in the Fed's economic gun.  With interest rates at nearly zero, consumers are still not buying and banks seem reluctant to lend putting the brakes on the weak (if any) recovery.  By "printing more money" and buying U.S. Treasuries, the Fed is hoping to push longer term interest rates down which will encourage both corporations and individuals to borrow more.  Those investors that sell their bonds to the Fed will use the proceeds to buy other assets like equities and corporate bonds which will push their prices up making people feel richer with the ultimate result that they will spend more.  As well, by increasing the volume of U.S. dollars in the system, their value will decline resulting in a more competitive playing field for domestic products since imports will be more expensive.  

Japan has had a great deal of experience with QE.  The Bank of Japan lowered short-term interest rates to near zero in 1999 in an attempt to reflate their economy that had been circling the bowl since the late 1980s.  The BOJ flooded the country's banks with massive quantities of liquidity in an attempt to promote lending after buying bonds, asset-backed securities and equities.  The first round of QE by the BOJ started on March 19th, 2001.  The BOJ increased its target for "current account balances" at commercial banks far in excess of the required reserve levels, over-capitalizing the banks thus forcing them to lend more at minimal risk.  This pushed the overnight call rate to near zero.  At the same time, the BOJ committed to maintaining this policy until prices recovered to a stable  change of zero percent year over year.  Here's a chart showing the overnight call rate since 1990:

You can see that the overnight call rate fell to roughly zero percent in late 1995 and has pretty much been there ever since.

The BOJ increased the commercial bank current account balance from 5 trillion yen to 35 trillion yen over a 4 year period, flooding the market with paper money.  As well, the BOJ tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis in an attempt to push down long-term interest rates; flattening the yield curve and pushing down the cost of financing Japan's sovereign debt. Most recently, in early October 2010, the BOJ announced that it would ease its interest rate from 0.1 percent to between zero and 0.1 percent and examine the purchase of $60 billion in assets.  This was an attempt to push the value of the yen versus the U.S. dollar down to stimulate the local economy by making their exports cheaper; it didn't work as shown below.

The first phase of BOJ quantitative easing met with mixed success.  Inflation has not returned to the Japanese economy for any length of time; here's a chart showing the inflation rate since 1990:

Over the past 5 years, Japan's inflation rate has hovered between -2.5 percent and 2.3 percent with a mean of -0.09 percent.  For most of the past two years, the Japanese economy has experienced deflation. Oops that didn't work!

If the Bank of Japan intended to push down the value of the Japanese yen versus the U.S. dollar, here's how well that worked over the past 5 years:

Apparently, that was another whoopsy daisy!  In fact, the dollar is hovering near a record low in terms of the Japanese yen.

In addition, Japan's sovereign debt-to-GDP ratio is a staggering 181 percent of its GDP up from 156 percent at the end of fiscal 2008, the second highest in the world after Zimbabwe.  Their total debt is estimated to be at $10.14 trillion by the end of fiscal 2010, reaching 197 percent of GDP.  Apparently and yet again, that didn't work so well either.

The greatest risk of QE is that the methods used could trigger higher inflation than would normally be expected or even hyperinflation if too much money is created.  QE could also fail if banks are still reluctant to loan money to businesses or individuals or if both are reluctant to take on additional debt.  We can readily see from the Japan example that the great experiment that is Quantitative Easing can have repercussions that are exactly the opposite of what is intended.  With a debt of over $13.72 trillion as of today, that is the last thing that the United States economy can handle.  My greatest concern is that one of the causes of the Great Recession of 2008 stemmed from overuse of credit by individuals that are now just starting to save money.  The moves by the Federal Reserve and comments by other central bankers around the world tell us that the last thing any central banker wants us to do is save money.


Here's Ben Bernanke's defence of his QE position from the Washington Post.

References:

Did Quantitative Easing by the Bank of Japan Work?