1.     As the financial crisis has developed and increasingly affected real economic activity, the US Federal Reserve and the Bank of England (BoE) have resorted to progressively more aggressive and unconventional easing measures. While these measures have been described in the media as "quantitative easing" and even "printing money", these terms have not been used rigorously or even consistently. Commentators often misunderstand the significance of issues such as the payment of interest on reserves and the growth in base (central bank) money. It seems that the confusion is at least partly explained by the fairly superficial coverage of monetary policy implementation in economics textbooks, which abstract from certain details that are key to appreciating the differences between conventional easing, the
2.     This post is an ambitious attempt to provide an explanation of monetary policy easing that covers all the aspects necessary to understand both conventional and unconventional easing measures. Although there has been some such explanation in the media, RebelEconomist has not found it entirely satisfactory, and offers his own here. It is hoped that his combination of experience of central bank market operations and academic monetary economics might just produce an account of monetary policy that does not leave vital questions unanswered and expresses some ideas in a slightly different way that can provide fresh insight. The post classifies Fed and BoE easing policies as they have evolved through the crisis. It is argued that while both central banks' unconventional measures have always been specified in quantitative terms, they are more accurately described as quantitative liquidity, credit and term easing rather than quantitative monetary easing. Neither central bank has yet begun to print money.
3.     Given its objective, the post is long, so readers who are mainly interested in present policy may wish to
Fundamentals of easing
4.     Modern money (as opposed to commodity money such as gold coins) is debt; a readily transferable and widely accepted type of continuously redeemable debt. Typically money is
5.     To avoid going into the complexity and mystery of the monetary policy transmission mechanism, suffice it to say that, other things equal, an increase in the stock of money (also known as the money "supply", which perhaps confusingly implies a flow) has a stimulating effect on economic activity for a few months at least, and that
6.     The supply of money is, of course, regulated by the central bank. Although there is more than one type of money, elementary explanations of monetary policy often abstract from this complication by assuming that they are held in stable proportions defined by "multipliers", meaning that the central bank need only regulate the supply of one kind of money to control them all.
7.     The form of money that the central bank directly influences is commercial banks' current account balances at the central bank. Although central banks typically pay little if any interest on positive balances in these accounts, commercial banks nevertheless tend to keep their central bank current accounts in credit, for at least two reasons. First, these accounts are used to settle any transaction that the banks undertake with the central bank, and sometimes also to settle
8.     Banks' holdings of reserves for transactions purposes can be expected to be proportional to the size of their customers' demand deposits. An archetypal transaction that commercial banks undertake with the central bank is to buy and sell banknotes as their customers respectively withdraw and deposit currency (currency includes coins as well as banknotes, but coins are relatively insignificant by value and are not always a liability of the central bank). Transactions between bank customers generate
9.     Although reserves represent the interface of the central bank and the rest of the economy, the stock of banknotes is normally a far larger liability of the central bank. Commercial banks may exchange reserves for banknotes at par, freely and on demand, and together, reserves and banknotes comprise what is called base money. The central bank would be unwise to try to control the money supply via banknotes – restricting the supply of banknotes could trigger a panic run on any bank apparently having difficulty meeting customer withdrawals. Like reserves, however, the value of banknotes in circulation is related to the size of demand deposits. Just as reserves provide the basic type of money for banks, banknotes provide the most widely accepted and dependable form of money for individuals. The transfer of banknotes represents immediate, often unrecorded, settlement of a transaction, which makes banknotes most suitable for occasional, relatively small transactions outside of committed business relationships, and for this purpose individuals hold a buffer stock of banknotes representing some fraction of their deposits. This means that the central bank has some indirect control of banknote circulation via reserves.
10.     While the banking system as a whole can ultimately only acquire reserves from the central bank, commercial banks trade reserves between themselves by borrowing and lending for settlement in their central bank current accounts, generally from one day to the next. The interest rate in this
11.     Since it is a point that seems to cause some confusion, note that, although an individual bank does expend reserves when it lends to a customer, reserves are not consumed or transferred outside the banking system in the process, even if the borrower is a
12.     Central banks manage the stock of reserves in pursuit of both macroeconomic and microeconomic objectives. Their macroeconomic task is to use the influence of reserves to adjust the money supply and
13.     Note that interest rate targeting means that the textbook account of deposit money creation, in which the central bank supplies base money followed by an iterative process of bank lending and customers
14.     In principle, the central bank could fix its targeted interest rate by adding or subtracting reserves through any type of transaction that settles in commercial banks' current accounts, relying on the substitutability of reserves and
From interest rate targeting to paying interest on reserves
15.     Naturally, when debt is used as a monetary asset, there is potential for confusion between the interest rate on the central bank's target debt instrument, such as overnight
16.     Not all central banks buy
17.     For an interest rate targeting central bank, its operational objective is to hold the rate of interest on its target debt instrument close to the target with minimal variability. To this end, central banks use two basic trading strategies. Their primary strategy is to attempt to estimate the change in reserves necessary to guide the interest rate to the target and arrange one or more transactions to engineer that change. The estimation problem is more one of allowing for scheduled flows like maturing central bank loans and anticipating the actions of institutions and people, known as autonomous factors, rather than identifying and using the money demand curve. Usually, the adjustment required is an injection of reserves to replace maturing debt held by the central bank. The central bank then establishes transactions to make that adjustment by offering to buy or sell as necessary the corresponding amount of debt, either at a fixed interest rate or by auction. Although the central bank usually deals with a limited set of counterparties, these may include
18.     In theory, the interest rate inelasticity of the demand for reserves means that a change in the target interest rate can be accomplished with a small change in the size of the next OMO, and also that a failure to make the correct size change could result in the new target interest rate being missed badly. In practice, because the central bank's money market counterparties know that the central bank has the market power to correct any persistent miss and is able to impose sanctions on any of them considered to be behaving unhelpfully, the process of setting interest rates is facilitated by a degree of cooperation. Normally, the mere announcement of a change in the target interest rate is sufficient to shift market interest rates to the new target.
19.     Note that the fact that the target and operational debt instruments may differ means that the bounds on the target interest rate may not exactly correspond to the rates at which the standing facilities are offered. In particular, because central banks generally only lend on a secured basis, unsecured
20.     As central banks have placed increasing importance on controlling, and being seen to control, interest rates, a natural development of their strategy has been to change the nature of base money itself to make their job easier. Since it is the interest rate inelasticity of the demand for reserves that makes market interest rates inherently volatile, and since it is the sharp difference between the return on adequate reserves – avoiding a penalty of some size – and on surplus reserves – zero – that causes the inelasticity, an obvious way to reduce the volatility of interest rates is to smooth this disparity. The opportunity cost of holding excess reserves can be reduced by paying interest on reserves. Effectively, this raises the dashed line in Figure 1, so that the money demand curve – or to be more precise, since the return on reserves now differs from the zero return on banknotes, the reserves demand curve – is flatter in the normal range of interest rates. Where there are mandatory reserve requirements, the sharpness of the shortfall penalty can be blunted by applying it to the average level of reserves over some maintenance period, so that a shortfall on one day can be offset against a surplus on another day. Assuming that an overdraft, even for one day, is still unacceptable to the central bank, reserves averaging works better when the reserves requirement is larger and the level of reserves varies around a level well above zero. Paying interest on reserves makes such a larger reserve requirement more acceptable to the commercial banks. For these reasons the European Central Bank and the Bank of England remunerate reserves, and the Fed had been asking the US Congress for permission to pay interest on reserves long before the financial crisis.
21.     To stabilise money market interest rates with maximum effectiveness, the reserves demand curve should be practically flat at the policy rate, which suggests that the interest rate paid on reserves should be close to the policy rate – but certainly not above it, which would establish an arbitrage opportunity. However, paying any interest rate approaching the policy rate encourages the use of reserves as an unbeatably secure investment. The solution adopted by the ECB and the BoE is to remunerate reserves holdings of up to the required size at their policy rate, but pay no interest on any amount above this.
22.     It is important to realise that, because, other things equal, banks can be expected to hold more reserves when they are remunerated, paying interest on reserves changes the relationship between the stock of base money and other economic variables, notably inflation. The introduction of voluntary reserve requirements and remunerated reserves by the BoE, which previously had no reserves requirements, provides a revealing case study of the effect of paying interest on reserves. Prior to the change in regime on May 18th 2006, banks' current account balances at the BoE were normally much less than £1bn. When the BoE began to pay interest on reserves at their policy repo rate, banks' current account balances increased to around £20bn almost immediately – the BoE simply bought more repo debt in its OMOs, on which it charged its repo rate, to accommodate the notified increase in demand for reserves remunerated at the same rate. Since the increase in the stock of reserves was equal to about half the value of the stock of sterling currency in circulation at the time, the "velocity" of base money (essentially the number of times in a year that the money stock would need to change hands to sell annual economic output at prevailing prices) fell by a third, yet the regime change had no noticeable effect on inflation or real output. Analysts accustomed to using base money growth to assess the monetary discipline of a central bank, assuming that the ability to freely switch from reserves to banknotes and vice versa makes them macroeconomically indistinguishable, need to revise their approach when interest is paid on reserves.
23.     Paying interest on reserves represents the apotheosis of interest rate targeting. Market interest rates on
24.     The efforts made by central banks to strengthen their grip on
The zero lower bound and quantitative easing in Japan
25.     If the policy rate is a target for some money market interest rate such as the interest rate on overnight
26.     In practice, central banks can succeed in lowering their policy rate to zero or even slightly less, partly because of real world limitations such as transactions costs, the convention of dealing in rounded interest rates and the finite capacity of the banking system, and partly because of the banks' willingness to cooperate with the central bank within reason. It might even be possible for a central bank to force its policy rate significantly below zero by imposing restrictions such as charging interest on reserves, but this has not so far been attempted, probably because it would generate undesirable distortions, such as driving banks to use banknotes instead of reserves wherever possible and to settle
27.     Once the policy interest rate reaches zero, however, it no longer provides a sufficient measure of the monetary policy stance, because the practicalities of fixing interest rates mentioned in the preceding paragraph combined with the flatness of the reserves demand curve at a zero interest rate mean that a zero policy rate is compatible with a range of sizes of the stock of reserves. This matters because any amount of reserves in excess of the supply necessary to sustain a zero interest rate on the policy debt instrument influences the interest rates on other debt types that are near substitutes for reserves. For example, if the policy rate is a target for the overnight interest rate in the
28.     Clearly, a precise description of the monetary policy stance when the policy rate reaches the zero lower bound could comprise a vector of interest rates on debt types that are progressively more distant substitutes of the policy debt instrument. A more straightforward approach, which is also consistent with a policy of leaving the market to determine how easing spreads beyond the policy debt instrument, is to express the monetary policy stance in terms of the quantity of reserves. The
Unconventional policy and the financial crisis
29.     Although the unconventional measures now being applied by the Fed are often described as quantitative easing, Fed policy developed from the opposite direction to the BoJ's QE policy in the sense that the Fed policy started with the aim of easing risk premia and evolved into monetary easing, whereas the BoJ policy began as monetary easing and compressed risk premia as it extended. Fed and BoE unconventional easing began as a response to the financial crisis, at a time when they were holding their interest rates well above zero because of the potential inflationary threat posed by the high commodity prices sustained into last year. In fact, it is questionable whether Fed and BoE unconventional easing could until recently even be properly described as monetary policy, although of course, as the financial crisis has increasingly restrained the real economy, both central banks have also been undertaking conventional monetary easing by cutting interest rates.
30.     At first, the financial problem was seen as one of a lack of liquidity (liquidity being defined here as ease of transacting rather than as, for example, abundance of money). As the US housing bubble burst and it became clear that many marginal borrowers were likely to default, investors shunned
31.     The idea was that the TAF would reduce the spread between the interest rates on highly liquid debt such as treasury bills and on bank debt collateralised by lower quality bonds. Besides narrowing spreads on
32.     Note that the TAF was not supposed to ease the credit risk premium. Contrary to what at least one academic has written, a repo loan is not free of credit risk just because it is collateralised by government bonds, and is not necessarily more risky when less creditworthy bonds are accepted as collateral. A repo loan suffers credit loss if the borrower defaults and the collateral is then worth less than the value of the loan, regardless of whether this shortfall arises from interest rate or credit risk. To ensure robust security, an initial margin or haircut is subtracted from the value of the bonds pledged as collateral in determining the amount of collateral required. When less creditworthy bonds are pledged, a larger haircut is applied to cover the expected value of the additional losses associated with credit impairment, so provided that the haircut is assessed correctly, a repo loan collateralised by
33.     As the financial crisis grew through 2008, with the Fed increasing the size and maturity of the TAF and adding new programmes like the Primary Dealer Credit Facility lending against a wider variety of collateral, the Fed reached the point where it was running out of treasury bills. The Fed could no longer continue to increase its lending against illiquid securities without either selling
34.     A similar programme, called the Special Liquidity Scheme, had already been introduced by the UK authorities on April 21st 2008. This allowed banks to exchange existing
35.     Following its discussion with Congress mentioned in paragraph 20, the Fed had in 2006 been granted authority to pay interest on reserves from 1 October 2011. This effectively allowed the Fed to borrow money by issuing
36.     Previously, creating a large amount of base money to fund expanded asset purchases would have been regarded as dangerously inflationary, but with interest paid on reserves, whose
37.     Some analysts define quantitative easing as something like "an increase in the size of the central bank's balance sheet through an increase in its monetary liabilities". Under this definition, the Fed had begun quantitative easing once it began to use remunerated reserves to fund its continued balance sheet expansion. But this would be a poor definition of quantitative easing anyway, because in theory any easing involves some expansion of the central bank balance sheet and increase in monetary liabilities, even if the inelasticity of the demand for unremunerated reserves allows this change to be small.
38.     The next easing step taken by the Fed was to start buying lower quality securities outright (ie beyond only taking them as repo collateral), albeit cautiously at first. On September 19th 2008, the Fed announced that it would begin buying
39.     Also on November 25th 2008, the Fed announced that it would begin outright purchases of $100bn of
40.     The BoE meanwhile had already adopted
41.     Although it might seem that every conceivable easing measure has by now been brought to bear on the financial and economic crisis, one, arguably desperate, tool remains. This is the convergence of monetary and fiscal policy, involving the central bank lending directly to the government to fund public expenditure on goods and services. Base money is created when the government draws down the loan. Monetary financing of government expenditure is the traditional definition, and RebelEconomist's preferred definition, of the term "printing money". It is unfortunate that this term has been devalued by being used during the easing campaign to express how readily central banks seem able to create resources to buy valuable assets in general, which is actually no more than the normal function of a monetary authority. Printing money to finance government expenditure would, however, be a big step, because it would mean that the central bank had given up its monetary policy independence and ability to prevent inflation when the need for easing has passed. When a central bank buys assets in the markets, because it pays the market price in base money, it should be possible for a