Resident Fellow Desmond Lachman

Desmond: Having reduced the federal funds rate to 0-0.25%, the Federal Reserve has for all intents and purposes exhausted its normal and primary instrument of monetary policy. Fearful that the US economy is now in a downward
spiral and that deflationary pressures might take hold, the Federal Reserve has now resorted to quantitative easing. It has done so in the sense that it is now aggressively expanding its balance sheet to bring down long-term interest rates in general and mortgage interest rates in particular.

By expanding its balance sheet from the present level of US$1.8 tn to a proposed US$3 tn, the Federal Reserve is hoping to exert a material impact on long-term borrowing rates for US consumers and corporations, which it hopes will be helpful in boosting domestic demand. It is also hoping that by increasing the demand for assets being held by the US financial system, its actions might be helpful in repairing banks' balance sheets.

Bernanke himself acknowledges, however, that a sustained recovery in the US is not possible in the absence of an adequate recapitalization of the US financial system. He is mindful of Japan's experience in the 1990s, where quantitative monetary policy easing did not succeed in reviving bank lending, despite the fact that the Bank of Japan flooded the market with liquidity. It did not succeed since Japan's undercapitalized banks chose to hoard liquidity rather than to on-lend it.

Yamori: The Japanese experience in the early 2000s suggests the dynamics of quantitative easing. Convinced that Japan's economic fundamentals were too severely distressed to be rectified with standard monetary policy measures, on March 19, 2001, the Bank of Japan announced a new policy of 'quantitative easing.' Under this policy, BoJ increased its current account target far beyond the level of commercial bank required reserves. This had the expected impact of reducing the already- low overnight call rate effectively to zero. In addition, BoJ committed to maintain the policy until the core consumer price index registered 'stably' a zero percent or an increase year on year. BoJ expanded the balance outstanding at the Bank's current accounts several times. For example, on December 19, 2001, the BoJ decided to raise the main operating target, the outstanding balance of the current accounts at the Bank, from 'above 6 tn yen' to '10-15 tn yen range'. In January 2004, the target range was raised to '30-35 tn yen'. The policy was in place for almost five years, and formally lifted on March 9, 2006.

Therefore, the worsening economic conditions will force central banks to resort to more aggressive quantitative easing until the economy recovers. In other words, after reaching zero interest rates, central banks have to do something if economic conditions become worse. The extension of target is a signal that the central bank considers the situation serious. During the quantitative policy period, some criticized that BoJ should try to increase the price level in order to make real interest rates negative. BoJ was reluctant to employ untraditional policies such as buying real estates and lending directly to private firms. So, quantitative easing was politically useful when BoJ was asked to stimulate economy further.

However, Fed Chairman Ben Bernanke calls this 'credit easing', saying it is aimed at stimulating borrowing and thus different from 'quantitative easing' used in the 1990s in Japan and now mulled by other central banks. What is your view?

Desmond: The US has not set a quantitative target for the amount of liquidity that it wishes into the system. Rather it has specified the quantity of bonds that it proposes to buy in the mortgage-backed security, the US government-agency, and the long-dated US treasury markets. It would seem that the Fed's primary goal is to affect interest rates in these markets rather than affect the amount of liquidity in the system.

Yamori: Japanese quantitative easing policy focused on the provision of liquidity to banks. Ample liquidity would likely encourage banks to extend more loans to firms. Currently, as the problem is not about liquidity, but about risk-taking ability, Japanese 2001 type quantitative easing is not enough. Based on my own research (Takeshi Kobayashi, Mark Spiegel, Nobuyoshi Yamori, "Quantitative Easing and Japanese Bank Equity Values", Journal of Japanese and International Economies 20, 2006, 699-721), the extending of the quantitative easing policy was only effective when larger longterm government bond purchase plan was accompanied.

Recently, the Fed started to purchase long-term bonds. Based on Japanese experience, I expect that the policy supports the US economy through the decrease of long-term interest rates. As the situation is the most serious since the Great Depression, it is quite reasonable that the Fed focused not on liquidity problem, but on the credit problem. In other words, who assume risks is a key issue in this current situation. Now, nobody except public sectors can assume risks. Therefore, I agree on the policy that the Fed currently conducts.

Please explain whether a 'zero interest rate policy' is a must for introducing quantitative easing?

Desmond: In principle, a central bank can resort to the unorthodox route of quantitative easing before reducing shortterm interest rates to zero. However, in practice central banks would refrain from so doing, since going the route of quantitative easing signals the central bank's assessment that something is very troubling about the state of the economy. The normal practice would be not to resort to quantitative easing until the orthodox instruments of monetary policy were exhausted.

Yamori: In theory, quantitative easing (aiming to decrease long-term interest rates directly) and zero interest rates policy (aiming to decrease short-term interest rates) are different. However, in practice, the central banks employ quantitative easing after they find that zero interest rates policy is not enough. This is because the traditional theory tells us that central banks should provide liquidity not credit. In general, long-term interest rates should be determined by market forces not by the government.

If money is supplied in high volume through quantitative relaxation, the interest rate--the price of money--should decline rapidly. In fact, as a result of this quantitative relaxation, the unsecured call rate started to shift virtually to zero percent. When the interest rate reached zero, the zero interest-rate policy cannot provide further relaxation. So, at that point, it was no longer possible to adopt a policy which targeted the interest rate (to be exact, the nominal interest rate). However, quantitative relaxation could still continue even when the interest rate became zero.

Do you think the new tool adopted by the Central Banks of 'big-three' economies is a step in the right direction? What, in your view, is the correct way of managing this process?

Desmond: Quantitative easing by the Federal Reserve is certainly a step in the right direction. However, it is highly unlikely by itself to produce a meaningful US recovery. Rather what is required is that the Fed's quantitative easing is supported by policies that succeed in adequately recapitalizing the banking system that gets a better structured and more front-loaded fiscal stimulus package than the one presently in place.

Of the large central banks, the ECB is the one that is most behind the curve. Despite a weakening European economy, the ECB is yet to reduce short-term interest rates to zero, let alone resort to quantitative easing.

Yamori: Yes, I think this is a right decision. In other words, there is no other choice for the central banks.

However, note that Japanese 2001 quantitative easing failed to increase bank lending. As banks with fragile capital
conditions could not take more risks, banks held only government bonds. So, the policy was not so effective to stimulate economic activity. The basic issue is how to rebuild a stable financial system.

What could be the long-term impact of quantitative easing on their respective economies?

Desmond: The long-term risk of quantitative easing is that it could lead to high inflation if the Fed is not aggressive in withdrawing liquidity and allowing interest rates to rise when the economy recovers and when the banking system is restored to health. There is also the real risk that quantitative easing could provoke a dollar crisis. Despite these risks, the present priority of US monetary policy has to be that of avoiding the very real threat of the US economy entering a downward deflationary spiral.

Yamori: Based on the Japanese experience, the timing of the end of the policy is politically controversial. The reason that quantitative easing has an effect is that larger targets mean longer zero interest rates policy period. If inflation rates suddenly increase, central banks may not flexibly raise the interest rates. Furthermore, current economic troubles will be managed by quantitative easing. However, this is the best central banks can do. So, after the situation becomes stable, central banks have to build a new scheme so that potential risks are manageable. If not, the next crisis will be too large to be managed by our central banks.

Do you think quantitative easing is suitable to other economies as well?

Desmond: Quantitative easing is clearly not meant for all economies. One has to look at matters on a case by case basis. It is clearly not suitable for countries that have poor economic fundamentals and weak currencies, as these countries would be most susceptible to an unwelcome burst in inflation.

Yamori: If short-term interest rates are not zero, the central banks have to reduce the interest rates before conducting quantitative easing. If short-term interest rates are zero, quantitative easing policy is a choice. However, quantitative easing policy is not strong in terms of stimulating economy. Some policies to strengthen the bank's ability of risk-taking should be accompanied.

Desmond Lachman is a resident fellow at AEI.