Unconventional Monetary Policy in Practice. A Comparison of 'Quantitative Easing' in Japan and the USA

Diploma Thesis, 2009
105 Pages, Grade: 1



1. Introduction

2. “Conventional” Monetary Policy Instruments
2.1. Open Market Operations
2.1.1. Outright Transactions USA Japan
2.1.2. (Reverse) Repurchase Agreements USA Japan
2.2. Standing Facilities
2.2.1. USA
2.2.2. Japan..
2.3. Reserve Requirements..
2.3.1. USA
2.3.2. Japan..

3. The Macroeconomic and Financial Conditions prior to the Introduction of Quantitative Easing
3.1. USA
3.2. Japan.

4. Preparing the Path for Quantitative Easing: The Ineffectiveness of “Conventional” Monetary Policy.
4.1. USA
4.2. Japan.
4.3. The Way Out: Quantitative Easing and Other “Unconventional” Measures
4.3.1. Shaping Expectations.
4.3.2. Changing the Composition of the Balance Sheet..
4.3.3. Increasing the Size of the Balance Sheet: Quantitative Easing.

5. Quantitative Easing in Practice: Commonalities and Differences of Two “Unconventional” Monetary Policy Approaches
5.1. Introduction of QE
5.1.1. Japan..
5.1.2. USA
5.2. Active QE.
5.2.1. Japan..
5.2.2. USA
5.3. Passive QE
5.3.1. Japan..
5.3.2. USA ..
5.4. Direct Lending to Borrowers and Investors.
5.5. Effects/ Success of QE.
5.5.1. Balance Sheet. Japan USA
5.5.2. Long-Term Interest Rates (Yield Curve), Money Market Developments and Inflation... Japan USA.

6. Conclusion..

7. Bibliography...

8. Appendix
8.1. Charts
8.2. Abstract (English).
8.3. Abstract (German)

1. Introduction

The current economic and financial crisis is considered to be the worst recession since the “Great Depression” in the 1930s. Some argue that it is even worse than that. Not only that many economies around the globe experience negative GDP growth rates, but also large parts of the banking system came into severe difficulties thereby causing a threat for the stability of the overall financial system. Under these circumstances, central banks in most industrial countries have lowered their key short-term interest rate targets to nearly zero.

However, as it turned out, in these extraordinary times “traditional” monetary policy responses in terms of variations of interest rate targets might not be sufficient in order to successfully master the current challenges. As a consequence, many central banks introduced so called “unconventional” monetary policy measures, which are generally summarized under the term “Quantitative Easing (QE)”. The concrete actions attributable to QE can be subdivided into “active” and “passive” QE. Active QE, which is at the discretion of the central bank, refers to outright purchases of government securities or other assets. Passive QE, on the other hand, is at the discretion of the central bank’s counterparty and means that counterparties can approach the central bank to obtain funds, given their ability to provide eligible collateral. Both have in common that aim to achieve certain - often country specific - targets by increasing the overall liquidity in the banking system.

The Bank of England (BoE), for example, announced in March 2009 to purchase GBP 75 billion of assets via reverse auctions because it feared that the achievement of its final target - an inflation rate (CPI) of 2 percent - is in danger. In May, the UK’s central bank decided to provide additional GBP 50 billion for further asset purchases. The BoE’s QE approach focuses primarily on the purchase of government debt (“gilts”). In addition, also corporate bonds are included. The introduction of QE in the UK was accompanied by a policy shift that places a higher weight on the quantity of money supplied rather than the short-term interest rate (“bank rate”). And also the European Central Bank (ECB) is active on the fields of unconventional monetary policy. In fact, as the current ECB president Jean-Claude Trichet points out, the European central bank was “the first central bank to take non-standard measures” by providing “additional liquidity to banks with immediate liquidity needs” at the beginning of August 2007. Since the banking system is more important for corporate financing in Europe than in Anglo-Saxon countries like the US or the UK, its primary concerns are the strains in the banking system. To face these strains, the ECB started very early to follow a “fixed rate full allotment” approach under which, in contrast to the previously applied variable rate tender procedure, commercial banks can obtain as much liquidity as they want at the prevailing interest rate target. In addition to this, the European central bank considerably increased the maturity (up to 12 months) and frequency of its liquidity-providing operations as well as the range of eligible collateral. The most recent (May 2009) measure announced by the ECB is a purchase program to buy covered bonds of about €60 billion, which can be considered as active QE. However, the primary focus of the ECB’s use of unconventional monetary policy lies, as just mentioned, on the extension of its existing liquidity-providing facilities, by which it heavily and also at an early stage of the current crisis increased the liquidity within the banking system. The problem pressure the American central bank (Fed) is currently facing is, to a certain degree, comparable to the one its European counterpart has to deal with: In both areas, fighting the strains in the banking system became one of the main tasks of monetary policy. In order to do so, the Fed relies on a threefold approach: First, it provides liquidity to banks and depository institutions on a short-term basis. For example, it introduced a liquidity-providing standing facility for primary dealers (“Primary Dealer Credit Facility”), which are not allowed to obtain funding through “traditional” standing facilities. Secondly, due to the comparably high significance of capital markets for corporate financing in the US, the Fed engages directly with borrowers and investors in key credit markets. And thirdly, it introduced several purchase programs for long- term government securities (up to $300 billion) as well as for government-sponsored enterprise debt and mortgage backed securities (up to $200 billion and up to $1.25 trillion, respectively).

Yet QE is not a phenomenon of the current crisis, it had been implemented for the first time more than eight years ago: The Bank of Japan (BoJ), having unsuccessfully tried to end deflation and recession, opted for a radical policy change and introduced the then unknown QE-policy in March 2001. When the Fed announced to engage in outright purchases of certain problematic assets as well as of government securities, many commentators made oversimplifying cross references to the Japanese QE-policy between 2001 and 2006. However, as Fed Chairman Ben Bernanke points out, the Japanese QE approach differs fundamentally from the QE approach the Fed currently pursues. In fact, when talking about the Fed’s current monetary policy, he refers to “Credit Easing (CE)”, which he opposes to QE as pursued by the BoJ.

It is therefore the aim of this diploma thesis to examine the differences between QE applied by the BoJ between 2001 and 2006 and the current QE policy pursued by the American central bank (although Bernanke calls the Fed’s approach CE, for reasons of easier comparison I will refer to QE most of the time). The questions I try to answer are what different macroeconomic and financial developments forced the to two central banks under considerations to believe that their respective toolkits of conventional monetary policy instruments are not sufficient for addressing these developments, in which way their respective QE regimes differ from each other, how these differences affected certain variables like the size of the central bank balance sheet and finally to what extend today’s US and Japanese monetary and also fiscal policy decision makers took into consideration the experiences Japan made in the last two decades when trying to address the current strains in the financial system and in the economy as a whole. For this purpose I proceed as follows: After reviewing the range of traditional monetary policy instruments at the disposal of the Fed and the BoJ, I focus on the economic conditions prior to the introduction of QE in the US and Japan, respectively. This is the basis for a close examination of commonalities and differences between the two QE regimes, which is done in the following part. I conclude with an evaluation of the implemented measures.

The main findings are as follows: First, the BoJ formally introduced QE on a certain date and also explicitly used the words “Quantitative Easing”. The Fed, on the other hand, neither used the term “Quantitative Easing” in its official statements (also not “Credit Easing”) nor was there a formal starting date. Secondly, although there are certainly parallels between the particular macroeconomic and financial environments that form the motivation behind the implementation of “unconventional” monetary policy measures by the two central banks under consideration, the differences in the economic performance are nevertheless the factors that shape the respective QE policies the most: Whereas the Japanese economy suffered from a prolonged deflation, the distinctive characteristics of the current US recession are severe problems within the banking system. Hence, the primary aim of QE in Japan was fighting deflation, whereas the American central bank addresses mostly strains in the banking system. Thirdly, the two QE approaches differ fundamentally with respect to their main policy targets. The BoJ switched from short-term interest rates to total reserves of commercial banks held at the central bank (i.e. the BoJ). The Fed, in contrast, keeps targeting short-term interest rates. This is clearly reflected in the respective monetary policy arrangements, which leads us to the fourth ground on which differences can be identified: QE by the BoJ consisted to a good deal of active QE in terms of outright purchases of Japanese government securities (JGBs), whereas the Fed currently follows a somewhat broader approach: Since interbank markets are not functioning as desired, it tries to engage with as many market participants as direct as possible. Therefore the Fed has introduced a much broader range of new instruments than its Japanese counterpart did between 2001 and 2006. As a result, the Fed’s balance sheet expansion was considerably larger than the one in Japan. (see Bernanke 2009a; Bank of England 2009; Trichet 2009; Pradhan 2009; Eichengreen/O’Rourke 2009).

2. “Conventional” Monetary Policy Instruments

Already 1969, Nobel Prize-winning Milton Friedman points out three main objectives that central banks should achieve when conducting monetary policy. The first one - “preventing money itself from being a major source of economic disturbance” - is, albeit appearing to be trivial, arguably the most important one. Having in mind the severe monetary policy mistakes by the Fed, that exacerbated the Great Depression in the 1930s, Friedman concludes that a central bank should “avoid drastic and erratic changes of direction”. His second proposition, “keeping the machine well oiled”, refers to the fact that a basic prerequisite for prospering economies are stable but also flexible prices and wages. At long last, monetary policy should in principle also focus on “offsetting major disturbances in the economic system arising from other sources”, although he stresses the limitations of monetary policy in dealing with disturbances in general (see Friedman 1968, p. 12-14).

Nowadays, a good deal of Friedman´s proposals is commonly agreed upon as being the main final targets a central bank should strive to achieve. The importance, however, that the big central banks attach each of these objectives, differs from institution to institution. Whereas Japan’s central bank primarily aims at “achieving price stability, thereby contributing to the sound development of the national economy” (see Bank of Japan 1997), the Fed’s mandate incorporates a broader range of objectives, namely “maximum employment, stable prices, and moderate long-term interest rates” (see The Federal Reserve Board 2008). So while the BoJ sees stabilizing the price level as its main responsibility, the Fed has three final targets of which price stability is merely one of them.

Achieving a certain final target, however, stands at the end of a rather long chain of monetary policy implementation, which consists of an operational target, an operational framework that enables the central bank to control the operational target and finally the use of monetary policy instruments in order to achieve the operational target. The connection between the operational target and the final target is made via an intermediate target, that can be controlled or at least influenced through the operational target and that has a stable relationship with the final target. In the particular case of the Fed and the BoJ, the operational target is in both cases the overnight market interest rate, which is called “federal funds rate” in the former and “uncollateralized overnight call rate” in the latter case. The operational framework determines the range of available instruments, the counterparts with whom a central bank should conduct business and the range of eligible collateral. All these aspects will be discussed in the following subchapters. The intermediate target is usually constituted by a monetary aggregate, M1 for example, though the importance of monetary aggregates as intermediate targets declined in recent years to some extend (Bindseil 2004, p. 7-9).

What now follows is a description of the instruments - including their requirements and the involved counterparties - modern central banks in general and the two monetary institutions discussed in detail use to exert control over short-term interest rates.

2.1. Open Market Operations

The following part outlines the general procedure as well as the specific characteristics of open market operations in the US and Japan prior to the introduction of QE. These operations, which are essential for the implementation of monetary policy, can be divided into two main subgroups, namely outright transactions and (reverse) repurchase agreements. Today, open market operations are regarded as the most important class of monetary policy instruments for influencing short-term interest rates. Though there are different types of such operations, they have some commonalities. In contrast to standing facilities, which will be discussed below, they are only conducted at the discretion of the central bank. Therefore, if one considers “ideal” open market operations, it is not possible for market participants to anticipate its implementation (see Bindseil 2004, p.145-147). In practice, however, many central banks (the ECB, for example) conduct (at least certain types of) open market operations on a regular basis (see ECB 2002, p. 7).

Concerning the procedure of liquidity-provision or liquidity-absorption, regardless of the type of open market operation, fixed-rate or variable-rate tender procedures have become the main tool for open market transactions between the central banks and eligible counterparties. If, for instance, a monetary institution decides to provide liquidity through a fixed-rate tender, it pre- announces the interest rate at which the counterparties can submit the amounts they wish to obtain. Unfortunately, this procedure has some important limitations, mostly because counterparties tend to bid for larger amounts than they actually want to obtain since they know that the actual amount allotted to them is just a fraction of their initial bid. This problem can be avoided by applying variable-rate tenders, where bidders are asked to submit rate/quantity pairs, which results in a downward-sloping demand curve. Now the central bank has to choose a marginal rate. All bids that lie above this particular interest rate and a predetermined minimum bid rate will be fully allotted, whereas rate/quantity pairs below the marginal rate will be refused. Bids that have been submitted exactly at the marginal rate will be allotted concerning to an allotment ratio that has to be specified by the central bank. The counterpart to fixed-rate as well as variable-rate tenders are bilateral operations, where the central bank engages directly with one or more counterparties, which could also include sales on the stock exchange. However, this kind of transaction procedure is barely used (see Bindseil 2004, p.162-163).

2.1.1. Outright Transactions

Regarding the different types of open market operations, outright transactions, which include purchases or sales of securities, are primarily used for structural liquidity-provision or for liquidity-absorption from the banking system. In general, both the Fed and the BoJ try to avoid draining reserves by creating a so called “structural liquidity deficit”, whereby they inject less liquidity through outright purchases than is demanded so that there ideally remains a constant need to add reserves, which is typically done via reverse operations (see Bindseil 2004, p.154-155 and BIS 2001, p. 17-18). USA

In the US, outright transactions and open market operations in general are carried out by the Federal Reserve Bank of New York on behalf of the Federal Reserve, which, in turn, has been authorized by its central decision-making body, the Federal Open Market Committee (FOMC). At the Federal Reserve Bank of New York, the division in charge of open market operations is called the “Open Market Trading Desk” or, in short, the “Desk”. Although the operational target is the uncollateralized lending rate between banks - the federal funds rate - the Desk actually conducts business mostly with so called “primary dealers”, which are banks and securities brokers. This procedure nonetheless affects reserves of the banking system held at the Fed since all primary dealers have clearing accounts at depository institutions. These accounts are used for the transactions between the Fed and the primary dealers. Thus, clearing account movements also lead to fluctuations of reserve holdings. In general, the Desk tries to achieve through its open market operations an equilibrium of supply of and demand for Federal Reserve balances at the prevailing federal funds target rate. If a deficit or surplus of reserves is perceived to be structural, the Desk conducts outright purchases or sales of assets through variable-rate tender procedures. Even though the domestic “System Open Market Account (SOMA)”, which administrates all domestic securities held outright, accounts for the bulk of total reserves supplied through open market operations (Chart1) (stock variable, average of 2006, so before financial turmoil started: $762.478 billion), reverse operations (stock variable, average of 2006: $24.863 billion, see The Federal Reserve Board 2009) are far more common.

When considering an outright transaction, the Desk has to pay attention to aspects like the maturity of the security or the liquidity of the relevant market. Therefore, the Desk generally focuses on US Treasury securities since the respective market is the broadest and most liquid one in the US. Concerning the maturity of the securities, the Federal Reserve imposed guidelines limiting the percentage share of certain maturities in its portfolio to avoid distortions of the yield curve, allowing for larger amounts of short-term securities. As a result, in 2006 about half of the securities in the SOMA portfolio had a maturity of one year or less (Chart2) (see Bindseil 2004, p. 155 and 163; Board of Governors of the Federal Reserve System 2005, p. 35-39; Federal Reserve Bank of New York 2007a, p. 14-24; Federal Reserve Bank of New York 2007b). Japan

Japan’s central bank does, like the Fed, focus on the overnight market interest rate - the uncollateralized overnight call rate - as the operational target. But whereas monetary policy implementation in the US relies heavily upon transactions between the Federal Reserve and a limited number of primary dealers - 19 as of September 2008 - the circle of eligible counterparties in Japan is larger: Prior to the introduction of QE, it ranged from about 30 to 50, depending on the type of transaction and has been expanded considerably after 2001. Counterparties can be banks, securities companies, securities finance companies and money market brokers. In contrast to US primary dealers, however, all of them have to maintain reserve accounts at the BoJ. In general, Japan’s central bank conducts more open market operations, or rather repurchase transactions, than its American counterpart: While the first one has to engage in open market operations several times a day to offset undesired liquidity fluctuations, the latter one conducts such transactions typically just once a day. The reasons for this might be the higher volatility in autonomous factors, such as banknotes in circulation, as well as the illiquidity of some market segments in Japan. This could also serve as an explanation for the higher spectrum of instruments at the disposal of the BoJ. Before turning to the concrete design of outright transactions in Japan, it should be noted that many of the instruments in the toolbox of the BoJ have only recently been introduced. Some forms of outright transactions and reverse operations as late as the end of the 20th century. The reason for this was the BoJ’s focus on its lending rates to banks as the primary monetary policy instrument. This was necessary due to the underdevelopment of the Japanese securities market, which made open market operations very difficult. In 1962, however, with bond and bills markets becoming more and more liquid, the BoJ started focusing on open market operations in order to achieve its policy goals.

If the Policy Board, which is the BoJ’s decision-making body, perceives that there is a structural shortfall of reserves, it conducts outright purchases of long-term Japanese government bonds (JGBs) with maturities ranging from 10 to 20 years via flexible-rate tender (Chart 3, note: the MPM on May 18, 2001 decided to extend the range of eligible JGBs, therefore also JGBs with a maturity of less than 10 years are included in the graph because earlier data was not available. Anyway, their total amount was still not significant at that time). The total amount bought should, on average, match the net increase in banknotes (Chart 4). Currently the BoJ purchases long-term JGBs on an outright basis about twice a month.

In contrast to the Fed, the BoJ also conducts outright purchases on a daily basis to address temporary liquidity-needs. Therefore, it purchases short-term government securities, namely Treasury bills (TBs) and financing bills (FBs). Yet two of the BoJ’s short-term outright transactions differ somewhat from the usual definition of this monetary policy instrument: The first variation includes buying so called “master bills”, which are bills issued by counterparties solely for the purpose of engaging in transactions with the BoJ. These bills, in turn, are backed by a pool of eligible collateral. The second variation of outright transactions implies purchasing bills collateralized by eligible corporate debt obligations, such as corporate bonds or asset-backed securities. All of these short-term outright transactions have in common that the maturity of the assets bought under such arrangements normally does not exceed 4 months. Finally, it should be mentioned that the BoJ conducts more repurchase than outright transactions, whereas the majority of funds is provided through the latter open market instrument (Chart 5). And in general, far more liquidity-providing than liquidity-absorbing operations are conducted. Obviously this pattern resembles the one described above when discussing the Fed. Concerning liquidity-absorbing outright transactions, the BoJ has the possibility to sell JGBs for addressing long-lasting liquidity-surpluses as well as TBs, FBs and bills issued by the BOJ with a maturity of up 3 months for reducing liquidity on a short-term basis (see BIS 2001, p.12, p. 17-19, p. 28-33, p. 47; Bank of Japan 2004a, p. 124-125; Bank of Japan 2007b; Bank of Japan 2009b; Bank of Japan 2008a, p. 15-17).

2.1.2. (Reverse) Repurchase Agreements

In contrast to outright transactions, (reverse) repurchase agreements are used to (absorb) provide liquidity on a temporary basis. This implies that the central bank does not ultimately buy or sell assets but rather buys or sells assets while at the same time predetermining a fixed date in the future for returning or re-obtaining the asset. For the duration of the transaction, the ownership rights of the assets are transferred to the buyer. Such transactions are mainly used for addressing short-lived liquidity fluctuations that might drive the short-term interest rate too far away from the target rate (see Bindseil 2004, p.156; ECB 2002 p. 82). USA

In the US, it was not until the 1970s that (reverse) repurchase agreements became the dominant monetary policy tool for addressing temporary deviations from the reserve levels consistent with the federal funds rate. Nowadays, the Fed arranges such transactions on a very frequent basis, with short-term repos, especially those with overnight maturity, accounting for the vast majority of repurchase agreements: In 2006, 247 repos with a maturity of not more than 13 days had been arranged, compared to just a weekly long-term repo with a maturity of 14 days. As noted earlier, central banks try to create a “structural liquidity deficit” to avoid draining reserves. As a consequence, reversed repurchase agreements, which aim at absorbing liquidity from the banking system, have not been conducted at all in 2006. Concerning the range of eligible collateral, the Desk conducts three different operations simultaneously. In the first tranche, only Treasury securities are eligible. The second, in addition to Treasury securities, also allows for federal agency obligations. While these two types of collateral are also eligible in the third trance, primary dealers, who are the Desk’s counterparts, may also try to obtain reserves in exchange for mortgage-backed agency debt. After all bids have been submitted, the Desk decides upon the allotment amount across the three trances according to the attractiveness of each bid relative to the market price of the respective type of collateral. Yet in practice most of the allotted reserves have been collateralized by Treasury securities (2006: 78% of all outstanding repos, see Federal Reserve Bank of New York 2007a, p. 19). Critics argue, however, that, in case of severe market disturbances, in which not all types of collateral might be available at reasonable prices, the Fed’s range of collateral accepted at repurchase agreements could turn out to be too narrow (see Bindseil 2004, p. 158-159; Federal Reserve Bank of New York 2007a, p. 16-19; Board of Governors of the Federal Reserve System 2005, p. 39-40). Japan

The BoJ relies, just like the Fed, heavily upon - due to the structural liquidity deficit mostly liquidity-providing - repurchase agreements to address short-dated liquidity fluctuations. The frequency of operations, however, is higher in Japan than in the US: While the Fed enters the market typically on a daily basis, the BoJ conducts repurchase transactions several times a day. Another difference regards the range of eligible collateral: whereas the Fed accepts merely government securities, government agency debt obligations or obligations that are fully backed by those agencies, the BoJ follows a broader approach, which manifests itself in the set of repos the Japanese central bank can choose from. Apart from purchasing JGBs, TBs and FBs under such an arrangement, the BoJ has also the possibility to buy commercial papers (CPs) issued by non-financial companies, with TBs and FBs accounting for the bulk of collateral used in the BoJ’s repos. The maturities of these transactions range from 3 to 12 months, which is considerably higher than in the US. A somewhat different kind of liquidity- provision under repurchase agreements are funds-supplying operations against pooled collateral, which is a loan with a maturity of up to 1 year. The pool of collateral is quite extensive, including a variety of government, government-backed and private obligations. If, on the other hand, the BoJ decides to absorb liquidity via reverse repurchase agreements, it can do so by selling JGBs, TBs, FBs. These operations are, however, like in the other country under consideration, relatively rare (see BIS 2001, p. 17-19, p. 28-33, p. 47; Bank of Japan 2007a; Bank of Japan 2009a; Bank of Japan 2008a, p. 15-17).

2.2. Standing Facilities

Analogous to the preceding subsection, the following two parts deal with standing facilities and reserve requirements - two other means of monetary policy that have a certain significance for achieving the operational target. Again, a theoretical assessment of these two instruments is followed by the practical implementation in the US and Japan. Though nowadays open market operations are the most important means of monetary policy implementation, this has not always been the case. Until the 1920s, standing facilities have not only been the oldest but also the most important monetary policy instrument. Its most striking difference from open market operations is the fact that eligible counterparties can use standing facilities at their discretion at any desired moment during business hours. In principle, one can distinguish between borrowing and deposit facilities. Whereas the first type is usually set above the overnight market interest rate and is liquidity-providing, the latter one has only recently been introduced by some central banks and serves as a liquidity-absorbing instrument. Today, borrowing facilities are usually designed as so called “Lombard facilities”. Under such an arrangement, the central bank grants a credit with a certain maturity - usually overnight - to counterparties, which in turn have to deposit eligible collateral. Standing facilities, especially the more important liquidity-providing facilities, contribute substantially to steering short-term interest rates. In the absence of such instruments, interest rates could exhibit extreme volatility. If, for example, a depository institution fails to obtain funds through open market operations or an expected payment from a counterparty has not been made, it can borrow funds at the borrowing facility. Furthermore, borrowing facilities contribute to the stability of the financial system, since banks can overcome temporary liquidity needs in case of either not smoothly functioning financial markets (for example a “credit crunch”) or individual financial difficulties that could lead to the collapse of the depository institution. Eligible collateral, however, is always essential for obtaining funds through borrowing facilities. Over the last years, though, widespread consensus has emerged among central banks that stabilizing functions of standing facilities should be separated from steering short-term interest rates, making sure that stabilization is at the discretion of the central bank (see Bindseil 2004, p.103-108).

2.2.1. USA

In the US, there is only a borrowing facility, which is called “discount window”. Prior to 2003, this term was used to summarize two lending programs called “adjustment credit” and the somewhat less important “extended credit”. Except for their importance, these facilities differed with respect to their credit period, with the first program addressing short-term and the latter longer-term liquidity needs. Yet both of them were set below the effective federal funds rate, which was problematic because it created arbitrage-opportunities that had to be prevented by the Fed. Therefore, there was a major revision of the discount window lending programs in 2003. As a result, the two programs had been replaced by “primary credit”, “secondary credit” and “seasonal credit” Lombard-type lending programs. Primary credit, representing the Fed’s main discount window program, is generally available to sound depository institutions on a short-term basis and is usually set about 1 percent above the federal funds target rate, although the spread might vary depending on the specific circumstances (Chart 6). There might also be situations in which primary credit is extended for periods of up to a few weeks. Secondary credit, on the contrary, is granted to depository institutions that are less financially sound and therefore not eligible to obtain primary credit. It is typically set 50 basis points above the primary credit rate. Finally, seasonal credit, which is based on market interest rates, is intended to provide funding for small depository institutions that face seasonal liquidity fluctuations. Regardless of the program, institutions that want to borrow through discount window programs have to be subject to reserve requirements. Eligible collateral, which is required for every discount window program, ranges from US Treasury securities over asset-backed securities to consumer loans. Therefore, compared to

the rather narrow list of collateral accepted by the Fed in its repurchase agreements, depository institutions have much more to choose from (see Board of Governors of the Federal Reserve System 2005, p. 45-50; The Federal Reserve Bank Discount Window & Payment System Risk Website).

2.2.2. Japan

Also the BoJ did not install a deposit facility and therefore relies exclusively on a (Lombard- type) borrowing facility, the so called “Complementary Lending Facility”, which is set above the overnight call rate. Yet in contrast to the US, the Japanese central bank does not offer several lending programs but only one. In principle, all counterparties that maintain accounts at the BoJ are eligible for obtaining funds through this borrowing facility. In practice, however, depository institutions are more likely to make use of it because securities companies and other eligible institutions must pay a higher tax on borrowed funds from this facility. Like the comparable facility in the US, the Complementary Lending Facility aims at providing merely short-term funding. More specifically, the maturity of the BoJ’s borrowing facility is usually overnight, with the rule that this facility can only be used on up to five business days in each maintenance period (1 month). The interest rate applicable to such loans is the “basic loan rate” (Chart 7). But other than primary or secondary credit, which are set at a fixed rate above the federal funds target rate, the spread between the Complementary Lending Facility and the overnight call rate might be altered at every Monetary Policy Meeting of the Policy Board. Then again, there are many similarities concerning the range of eligible collateral. Both, the Fed and the BoJ, accept not only government or government- guaranteed securities but also a broad variety of corporate bonds and private debt (see BIS 2001, p. 30 and 33; Olivei 2002, p. 40).

2.3. Reserve Requirements

The last monetary policy instrument to be discussed is the reserve requirement. Despite the incapacity to fulfill its initial purpose, namely ensuring banks’ individual liquidity against bank runs, and continually changing justifications for its existence during the 20th century, reserve requirements nevertheless remain an essential monetary policy instrument. Today, this instrument is considered to provide an important averaging facility, such that transitory liquidity-shocks do not cause fluctuations in short-term interest rates. Furthermore, reserve requirements might be viewed as a precondition for the effectiveness of open market operations since they create a demand for central bank money, which comes as follows: When applying reserve requirements, commercial banks are obliged to hold a certain fraction of customer deposits at their accounts at the central bank. Since this liquidity is no longer in the banking system, there is a so called “structural liquidity shortage” that makes commercial banks willing to engage in open market operations with the central bank in order to counterbalance this “loss” of liquidity (see Bindseil 2004, p. 179-180 and Keijser 2006, p.54).

2.3.1. USA

Until the end of the Second World War, the Federal Reserve was the only major central bank that used reserve requirements as a monetary policy tool, although, as mentioned above, its legimitation was somewhat different than today.

Reserve requirement ratios are adjusted annually in order to keep up with the growth of the banking system (reserve requirement rations mentioned below were in force in 2004). When applying reserve requirement ratios, the Fed takes into account the different sizes of institutions. Therefore, if a depository institution has less than $6.6 million on its customers’ transaction accounts (transactions accounts include checking and other accounts, from which payments can be made), it does not face any reserve requirements. For amounts ranging between $6.6 million and $45.4 million, the institution has to deposit 3 percent of the amount. Larger banks with more than $45.4 million on their customers’ transaction accounts face reserve requirements of $ 1 164 000 plus 10 percent of the amount exceeding $45.4 million. Unlike many other central banks, the Fed also accepts vault cash for the fulfillment. In recent years, however, there is an obvious downward trend of (absolute) required reserve balances held at the Fed (Chart 8). Except for two cuts in reserve requirement ratios in 1990 and 1992, this is primarily the result of the introduction of so called “retail sweep programs” that allow banks to transfer funds from reserveable transaction accounts to non-reserveable accounts, mostly money market deposit accounts (see Bindseil 2004, p.180; Board of Governors of the Federal Reserve System 2005, p. 41-42; The Federal Reserve Board 1997, p. 869-870).

2.3.2. Japan

In the 1940s, 1950s and 1960s, a good deal of the major central banks introduced reserve requirements as a monetary policy tool. Likewise, the BoJ discovered this instrument in 1959. As in the US, the Japanese central bank requires only depository institutions to hold reserve balances on their BoJ accounts, although also the other counterparties usually maintain current account deposits at the BoJ on a voluntary basis. In contrast to the Fed, however, the BoJ imposes reserve requirements on a broad range of deposits, including time deposits and foreign currency deposits and does not accept vault cash for meeting these requirements. The specific reserve requirement depends on the amount, the type of deposit as well as the currency and ranges from 0.05 to 1.3 percent (as of 2000), which has to be fulfilled over the maintenance period (1 month). Another difference is the fact that the downward trend of (absolute) required reserve balances is not present in Japan, which might be the consequence of increasing required reserve rates (Chart 9) (see BIS 2001, p. 37; Bindseil 2004, p. 182; Bank of Japan 2004a, p. 53).

3. The Macroeconomic and Financial Conditions prior to the Introduction of Quantitative Easing

Both countries have in common that they experienced a period of substantial economic growth prior to the introduction of QE, which was followed by a severe recession. This, in turn, made it necessary to expand the traditional toolkit of monetary policy instruments to include also “unconventional” measures. In what follows, these macroeconomic, financial and also political developments that paved the way for QE are examined. Again, the starting point is the US, preceding the examination of the Japanese experience between 1980 and 2000.

3.1. USA

The recovery of the American economy that started in November 2001 following the economic slowdown after the dot-com bubble burst was to a large extend fueled by a rather steep increase in house prices all across the country (Chart 10): From 1997 (Q1) to 2007 (Q2), where the housing market reached its cyclical peak, the “House Price Index (HPI)”, which is estimated by the “Office of Federal Housing Enterprise Oversight (OFHEO)”, nearly doubled (+96.4%).

Accordingly, also new housing starts (2005: 2 068 000, see U.S. Census Bureau) and sales of existing homes (2005: 7 076 000, see National Association of Realtors 2008) reached record highs. Having in mind that historically, house prices increased on average with the same rate as the overall inflation and that US population growth amounted to about 10 percent in the last decade, the dramatic price-increases on the real estate market seem to be nothing but speculative. The Fed, which lowered the federal funds target rate to 1 percent in June 2003, set the basis for this asset price bubble since many homebuyers took advantage of adjustable mortgage rates that have a low starting rate but can be adjusted after a lock-in period of usually three years. Of course the developments on the housing market had massive impacts on the overall economy: First, there was a direct effect through the employment of workers in construction as well as of employees in construction related industries (real estate, mortgage banking sector, etc.). Secondly, and perhaps more importantly, the increase in housing wealth was a major driving force for consumption expenditures since home owners took advantage of increasing real estate prices by borrowing against their homes, turning the savings rate negative. As a result, the consumption share of GDP rose from 68.7 percent in 2000 to 70.3 percent in 2006 (Q3). Investment, on the contrary, exhibited a somewhat lower growth rate, for the following reasons: First, the US-economy sustained a relatively high level of investment as a result of the dot-com bubble and secondly, the housing market pulled away resources from non-residential investment. GDP itself stopped its downward trend it had begun after the burst of the preceding bubble and reached a cyclical high in the 4th quarter of 2003 (+7.5%). Not surprisingly, the first years of the 21st century were also a period exhibiting a downward trend in the unemployment rate (Chart 11).

Many homebuyers that bought a house in recent years did so without adequate or even any funding. This balancing act did work out during the housing boom when house prices were rising and personal income was sufficient to cover the relatively low mortgage rates. But when the Fed started raising the federal funds target rate in June 2004, the burst of the bubble was merely a matter of time. It comes as no surprise that house prices nevertheless increased until 2007. The reason for this is the already mentioned lock-in period. Since a good deal of adjustable mortgages had been granted in 2003 and 2004, many home owners faced, depending on the type of mortgage, a considerable increase in their mortgage payment around 2006 and 2007. Home owners, who made no down payment and devoted a substantial fraction of their income to meet their mortgage payments already before the lock-in period had ended, faced severe difficulties. This lead to a dramatic increase in foreclosure rates and a reversion of the prevailing upward trend in house prices (Chart 10). The implications are straightforward: Consumption based on increasing house prices was not possible any more, which lead to a sharp decline of GDP growth and an equally sharp increase in unemployment (Chart 11) (see Baker 2006, p. 1-16 and Frankfurter Allgemeine Zeitung, 11/30/07).

Against the background of the collapse of two major investment banks (i.e. Bear Stearns and Lehman Brothers) and other financial institutions having severe liquidity problems as well as a serious recession that many observers, whether this is correct or not, lead to comparisons with the Great Depression of the 1930s, the Bush and the Obama administration, respectively, introduced several massive financial and economic stimulus packages. A discussion of these programs is beyond the scope of this diploma thesis. Therefore, they are just briefly mentioned. The “Economic Stimulus Act of 2008”, passed in February 2008, basically provided tax rebates to low- and middle-income taxpayers that amounted to $168 billion in total. The second and by far bigger stimulus package (“American Recovery and Reinvestment Act of 2009”) included $787 billion in tax cuts and new spending programs. To help restoring the smooth functioning of bank lending, the “Emergency Economic Stabilization Act of 2008” allowed the US Treasury to buy distressed assets from financial institutions (which was abandoned later) and to provide them with additional funding if necessary. This program, commonly referred to as financial bailout, amounted to up to $700 billion (see FoxNews.com 02/07/08; U.S. House of Representatives 2009; The Coloradoan 04/16/09; Reuters 11/12/08).

3.2. Japan

In the decades after the Second World War, the Japanese economy experienced a period of high GDP growth rates that culminated in the 1980, accompanied by an excessive boom in both the real estate and the stock market: Between 1985 and 1991, some segments of the real estate market rose by as much as 268 percent (Chart 12) and therefore much more than in the US. The Nikkei 225, Japan’s major stock market index, increased by 470 percent between 1980 and 1989.

Like in the US, monetary policy played a crucial role in fueling these asset price bubbles. Between 1985 and 1987, the Bank of Japan gradually lowered the official discount rate from 5 to 2.5 percent and left it there for two years, despite soaring asset prices. Equally important, however, was the liberalization of the financial sector in the second half of the 1980s, whereby large corporations gained access to national and international financial markets for acquiring funding. As a consequence, banks - until then the primary source for liquidity seeking corporations - lost a substantial part of their traditional client base. To compensate for these losses, financial institutions embraced smaller firms with limited access to capital markets and the property sector. This spurred demand for and prices of commercial as well as residential property, having the effect that property owning firms were able to increase borrowing against collateral, thereby causing additional demand for commercial real estate. Therefore, firms were the driving force behind the Japanese real estate bubble that was hence most excessive in commercial property. In the US, on the other hand, the recent housing bubble originated in the private housing market and was to a large extend fueled by non- commercial demand. When looking at the driving forces of GDP growth in the 1980s, one can see that this somewhat reversed pattern also holds true for the development of consumption and investment: Although both expanded rapidly in this decade, the latter component of GDP grew at a considerably faster pace. The reason for this was, as already mentioned, easier access to capital markets or bank loans, respectively, and, on the other hand, a reluctance of private home owners to borrow against their house to finance consumption expenditures. Hence it comes as no surprise that also the overall GDP expanded at a remarkable pace during the late 1980s: Between 1985 and 1990, the Japanese economy grew on average by 4.8 percent per year. Correspondingly, unemployment was not much of a problem in the 1980s (average: 2.5 percent, Chart 13).

However, like every other asset price bubble, Japan’s stock market and real estate bubble had to burst sooner or later, which happened at the end of 1989 with the Nikkei 225 stock market index reaching its all time high of nearly 40 000 points. Despite the burst of the stock market bubble, the BoJ started raising the discount rate to 6 percent in August 1990, apparently because real estate prices kept rising for about another year and concerns about inflationary pressure (1989 inflation: 2.3 percent) were present. Only after the real estate market begun to collapse, the BoJ started easing its monetary policy stance. Between June 1991 and September 1995, the official discount rate was lowered to 0.5 percent. But due to upcoming deflation, real interest rate changes were less pronounced than changes in nominal interest rates, thereby reducing the stimulative effect of nominal interest rate reductions. In 1999, after several years of recession and persistent deflation or very low inflation, the BoJ, by lowering its key policy rate (overnight call rate) to virtually zero, introduced a policy referred to as “zero interest rate policy (ZIRP)”. This is a striking contrast to the Fed’s policy in the current crisis, since it took the American central bank merely 16 months to reduce interest rates from their peak to near zero. It is worth mentioning that during the whole 1990s, the unemployment rate stayed below 5 percent and also GDP growth, though turning negative in some quarters, was merely stagnating at worst, which compares quite favorably to the current US macroeconomic performance. Thus, the different reactions of monetary policy in Japan and the US in terms of the key target rates are to some extend understandable. The comparably mild macroeconomic performance in Japan is partly the result of the 10 massive fiscal stimulus packages initiated in this particular decade, which, in total, exceeded 100 trillion yen (more than $1 trillion, with USD/JPY exchange rate as of 04/27/09) and included tax cuts as well as large scale public work programs. It is argued, however, that the main guiding criteria for financing construction projects was to ensure the political support of the construction industry, rather than the effectiveness or usefulness of the specific projects. This is seen as one of the main reasons why these huge stimulus packages were not able to shift the economy back on a solid growth path, except for a temporary recovery phase between 1994 and 1996, but resulted merely in a drastically increasing debt-to-GDP ratio: While this value amounted to only 46.8 in 1990, government debt reached as much as 106.2 percent of GDP only ten years later (2000). In addition to these stimulus packages, the Japanese government was also forced to pass several financial bailout packages to stabilize the banking system through recapitalizing undercapitalized but principally sound banks and the construction of a bridge bank facility to continue the operations of failed institutions. These measures became necessary as many banks suffered from “bad loans” since the collateral (i.e. real estate) upon which the loans had been granted, lost dramatically in value (see IMF 1998, p. 107-120; Powell 2002, p. 35-39; Makin 2008, p. 2-3 and OECD 2009).

4. Preparing the Path for Quantitative Easing: The Ineffectiveness of “Conventional” Monetary Policy

The economic and financial conditions that prevailed in Japan during the 1990s and in the US since 2007 affected the respective economies in quite different ways. It turned out, however, that in both countries “traditional” monetary policy reached its limits. Therefore, for addressing the particular problems, monetary policy had to break fresh ground. The specific developments, which made this shift necessary, are the main subject of the next two sections. The final section of this paragraph then examines on theoretical grounds possible “unconventional” measures at the disposal of the central bank that move beyond the traditional monetary policy toolkit. One of these is, in fact, Quantitative Easing.

4.1. USA

Rapidly falling house prices in the US had also indirect effects on the economy through the banking system, primarily because of a new trend that emerged in the financial sector: In the past, banks that granted mortgages kept them on their books. Yet in recent years, more and more banks switched to selling the mortgages they granted to other financial institutions. They did so by creating structured products, which consist of a portfolio of not only mortgages but also loans or credit card receivables. These products that are often called “collateralized debt obligations (CDOs)” or “collateralized loan obligations (CLOs)”, depending on the concrete composition of their portfolios, are then sliced into different tranches with the first tranche (“super senior”) being the first one to be paid out by the issuer and thus enjoying the highest credit rating. An essential drawback that comes along with such a procedure is the fact that the transfer of the credit risk distances the borrower from the lender. Usually, banks that granted a loan also had to bear the default risk. Therefore they had an incentive to carefully examine the prospective borrower and to deny credit if necessary. With creating structured products, however, the initial credit grantor transfers the credit risk to other financial institutions. Thus, its incentive to grant loans or mortgages only to borrowers that are trustworthy, declines dramatically. When house prices started falling and more and more home owners failed to meet their mortgage payments, structured products lost dramatically in value and their respective markets became more or less illiquid. As a consequence, so called “precautionary hoarding” took place: Banks hoarded large amounts of liquidity and refrained from lending in the interbank market because first, their own exposure to losses due to structured products and therefore their own liquidity needs were far from certain and secondly, as banks were aware of the fact that their competitors had the same problems, they knew that obtaining funds in the interbank market at reasonable prices when needed was hardly possible and thirdly, due to counterparty credit risk concerns, they feared that loans granted to other banks might default because of serious liquidity problems. Hence it should come as no surprise that the spread between the 3 months LIBOR, which is a reference rate based on the interest rates at which banks borrow unsecured funds for three months from each other, and the effective federal funds rate, widened considerably as banks were hardly willing to grant uncollateralized credit for a longer period than overnight (Chart 14). Furthermore, the Fed faced severe difficulties in keeping the demand for and the supply of reserves in equilibrium, which manifested itself in above-average deviations of the effective federal funds rate from its target (Chart 15).

These developments had, of course, also implications for private persons and companies, regardless of the particular creditworthiness: Even those banks, that received a good deal of the government aid granted in the course of the financial turmoil, made or refinanced 23 percent fewer new loans in February 2009 than in October 2008, which further exacerbated the economic downturn (see Brunnermeier 2008, p. 2-27 and The Wall Street Journal 04/2009).

Against this background, the American central bank started lowering its target rate pretty soon after it became obvious that the severe problems within the financial sector started affecting the real economy: On December 16, 2008, the Fed set the target rate as a corridor ranging from 0 to 0.25 percent, thereby ending a series of more or less drastic reductions of its operational target. With inflation averaging at 3.8 percent in 2008, this policy step was not primarily set to keep the price level from declining. Instead, the main motivation behind this decision was restoring the smooth functioning of interbank markets and of bank lending to businesses as well as to consumers, or, simply put, to end the “credit crunch”. It should be noted, however, that money market frictions accounted only for a part of the credit crunch. Rather, apart from simple deterioration of debtors’ financial positions, banks’ poor lending activities stemmed from the decline in their capital-to-asset ratios: With declining asset prices, the banks also had to reduce the asset side (i.e. loans) to keep the ratio more or less at the level they are required to maintain for regulatory reasons. They did so by raising rates, tightening credit standards or by simply refusing to roll over expiring loans. How severe the effects on the lending activity were can be shown by the following example: In order to keep the capital-to-asset ratio at, say, 10 percent, a bank has to reduce its assets by $10 for every $1 decline in capital, which is called “deleveraging”. Therefore it should come as no surprise that in July 2008, according to the “Federal Reserve Board Senior Loan Officer Opinion Survey on Bank Lending Practices”, 65 percent of the banks tightened their lending standards for small firms, which is a record high. This can also be seen when looking at various spreads: The spread between the bank’s own cost of funding and the rate charged to small firms had been raised by about 80 percent of US banks (July 2008). And external financing was not much of an option either because also the spread between investment grade corporate bond yields and the effective federal funds rate widened considerably (Chart 16). Since consumption accounts for a relatively large share of GDP in the US, it is worth noting that the same pattern holds true for the spread between the 30-year mortgage rate and the effective federal funds rate, as seen in Chart 17 (see Rosengren 2008, p. 1-12 and Bernanke/Lown 1991, p. 221-224).

So with an US economy facing a credit crunch that is brought about by malfunctions of interbank markets as well as banks’ reluctance in granting or extending new loans (either because of weak positions of potential borrowers or because of banks´ declining capital cover), reductions of the target rate were apparently not enough to restore confidence in interbank markets and to encourage banks to increase their lending activities to both businesses and consumers.


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Unconventional Monetary Policy in Practice. A Comparison of 'Quantitative Easing' in Japan and the USA
University of Vienna
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Geldpolitik, Fed, Bank of Japan, Monetary Policy, Unconventional Monetary Policy, Quantitative Lockerung, Quantitative Easing
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Matthias Reith (Author), 2009, Unconventional Monetary Policy in Practice. A Comparison of 'Quantitative Easing' in Japan and the USA, Munich, GRIN Verlag, https://www.grin.com/document/139627


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