Commenter Eoin asks a good question “Should the ECB be doing quantitative easing?” My thoughts are as follows.
First, standard monetary policy tools work pretty well until interest rates hit zero. When rates hit zero, these tools are pretty much exhausted (I know Willem Buiter has some interesting ideas to the contrary but these suggestions appear difficult to implement e.g. abolishing currency). If inflation is low, or particularly if there is deflation, this may still imply real interest rates that are higher than desirable.
If the policy rate is above zero—the ECB’s main refinancing rate is one percent—then the first thing you should do if you are concerned about the state of the economy (and believe inflation to be contained) is cut the policy rate. Before the ECB considers any non-standard monetary policy initiatives to stimulate the economy, they should use the room they have left to employ the standard tool.
Some ECB Governing Council members have, in the past, mused aloud that they don’t want to go to zero rates because they are worried about the complications associated with the zero-bound problem. Effectively, this is saying “I’m staying at one and not going to zero because I’d really like to be at minus one” which makes no sense.
Second, if short-term policy rates are at or very close to zero, that doesn’t mean other important rates on longer-termed debt such as those on government debt or mortgages are zero, so targeted intervention in these markets by the central bank could reduce these rates and help to stimulate the economy.
The science on this is a bit murky. On the one hand, you can argue that financial assets are like any other product and that increased demand for them drives up their price, which implies lower bond yields. On the other hand, the primary force determining prices for individual financial assets is arbitrage (ketchup economics!) so there will be limits to the price that the general public will pay for a particular asset if there is a close substitute available.
In practice, the way to think about this is that each asset usually has some underlying no-arbitrage price consistent with the case in which there are no transactions frictions but that, in reality, transactions frictons (bid-ask spreads, gaps in market pricing, difficulties in finding a buyer in tough times) are pretty important. So asset prices also contain a “liquidity premium” related to these frictions. If there is strong demand for an asset due to a central bank purchasing large quantities, this is likely to reduce the interest rate on this asset by lowering this premium.
However, in big markets like those for popular government bonds or mortgage backed securities, it appears that very large amounts of central bank money needs to be pumped into the market to obtain relatively modest reductions in rates. As of yet, the jury is out on the exact effect on interest rates of the Fed and BoE interventions, but they seem to have been modest. So, I’m all in favour of QE as practiced by the BoE and the Fed in the circumstances they found themselves in but it seems to be a pretty limited tool.
What about the ECB? Well, there’s a problem that applies to the ECB that doesn’t apply to the Fed and Bank of England. What do they buy? If they are focusing on government bonds, whose bonds should they buy? The BoE and Fed programs were open, clear and transparent. The ECB’s new program is secret and of uncertain length.
If the ECB were really undertaking QE as practised by the Fed, then they would first cut policy rates to near zero and then, if they were purchasing government bonds, they would purchase bonds of member countries in quantities proportional to their share of the ECB capital subscription. (Alternatively, governments could set up a Euro area bond with proceeds shared among the member countries and the ECB could intervene in these markets.) I would be all in favour of a program like this if the circumstances warranted (and I think they might).
That this is not what the ECB are doing shows that this program is not quantitative easing in the UK or US sense, but rather a program to deal with fiscal crisis in some member states, perhaps motivated by a desire to contains its effects on the rest of the Euro area’s banking system. I am far less enthusiastic about this opaque and poorly-motivated program.
Note that I got this far without using the press’s favourite term about QE “printing money.” Clearly, it’s not printing money, since these transactions are all electronic and may or may not lead to an increase in the stock of currency. Beyond that, while the central bank creates money in the process of purchasing these assets, it also does this when it undertakes its normal monetary policy operations. These are normally temporary operations but, in the case of the ECB, the massive increase in the size of the refinancing operations in recent years is “printing money” every bit as much as QE, though it is never described as such.
The picture usually painted of people running off to the shops to spend the newly printed money is pretty silly—the link between any particular measure of the money supply and economic activity is pretty tenuous. In any case, QE is better seen as a program aimed at getting down interest rates on important instruments rather than something to do with firing up the printing presses.