The main objective of a central bank is to maintain price stability in order to achieve economic growth and full employment. The most common tools a central bank uses to implement monetary policy and achieve these goals are. The interest rate that banks pay to the central bank to borrow this money is the discount rate.
As a result, the balance sheet of all participants, from the central bank to the banking sector and to the non-banking private sector, is affected. A central bank buys the long-term assets mainly from the non-bank private sector such as pension funds and insurance companies. The central bank, rather than printing new money to pay, credits the accounts of the sellers of these assets.
To finance these purchases, the central bank issues base money in the form of reserves held by other commercial banks.
The Transmissions channels of Quantitative Easing
- Portfolio Rebalancing
- Duration channel
- Signaling Channel
- Liquidity Channel
- Inflation Channel
Due to these conditions, any attempt by the central bank for expansionary monetary policy has no impact as the economy falls into a liquidity trap. Woodford (2012) called this process “pure QE” when the main goal is to inject money into the economy rather than to lower yields. Another channel through which long-term asset purchases can affect interest rates is signaling.
Expansionary monetary policy, such as quantitative easing, increases inflationary expectations and is a way of influencing interest rates (Cihak, 2009). On the one hand, economists such as Paul Kraugman and Scott Summer argue that when nominal interest rates are at the zero lower bound, expected inflation can stimulate the economy, but the economy is slow to move. Bernake and Getrler (1989) examine the impact of asset prices on the economy from a different approach, i.e. the balance sheet of the firm.
Thus, a flattening of the yield curve is likely to mean a decrease in the interest rates faced by households and businesses.
Uncoventional monetary policy by the Central Banks
The case of European Central Bank (ECB)
- Programs implemented by the ECB
As a direct result of these two refinancing operations, not only the ECB balance sheet changed, but also the monetary base.
Covered bond purchase programs 1, 2, 3
Asset-backed securities purchase program
Corporate sector purchase program
Public sector purchase program
- ECB Forward guidance
- The impact of forward guidance
- The case of Bank of Japan
- How successful was the QE exit for Japanese economy
- The case of Bank of England
- The case of Federal Reserve
- Financial effects
- Effects on interest rates
- Effect of Quantitative easing on inflation and output
The measure helped improve the functioning of the monetary policy transmission mechanism, support financing conditions in the eurozone, facilitate lending to the real economy and generate positive effects in other markets. In addition to the impact on money market rates, forward guidance also impacted the markets' uncertainty about the future of short-term interest rates. So before raising interest rates, the BOJ had to smoothly trim market participants' expectations in order to avoid any dramatic shift in the yield curve that could threaten the economic recovery.
In the United States, the implementation of the unconventional monetary policy began to take place in the fall of 2008. The next step came in October with the creation of the Commercial Paper Funding Facility (CPFF). The purpose of the Commercial Paper Funding Facility (CPFF) was to provide liquidity to the US issuers of commercial paper, thus increasing short-term liquidity.
The second round of Federal Reserve monetary policy to stimulate the economy was initiated in the fourth quarter of 2010 to kick-start the sluggish economic recovery. The main difference between QE3 and QE1 and QE2 was due to the fact that QE3 did not target a specific amount of asset purchases. The figure below shows the level of interest rates over the past two decades and how it has changed dramatically since the launch of QE in 2008.
Inflation
The lower limit was reached by 2009 and the long-term target remained between 0.25% and 0.5% over the following years. Core inflation is more CPI based as it measures the difference in inflation by calculating the prices of a basket of goods. On the other hand, core inflation is a measure of inflation that does not include CPI components such as food, energy, fuel etc.
In the following years after the crisis, headline inflation fell sharply to negative levels, even though the first phase of quantitative easing had already begun.
Real output
- Effects of quantitative easing on the exchange rate
- Global effects and spillovers
- Summary of the monetary policy of central banks
- Timeline of Quantitative Easing from the four Central Banks
Quantitative easing had an impact on the exchange rate of the USD against the EUR, especially at the beginning of its implementation. Neely (2014) argues that QE1 in the US not only lowered interest rates on governments such as Germany, Canada and Australia, but at the same time also depreciated the USD against the currencies of those countries. When the Fed started QE in 2008, we noticed the USD depreciating against the EUR.
Quantitative easing is implemented by central banks to deal with domestic economic problems. In his 2014 research, Neely found that the US QE1 announcements had a major impact on foreign markets by lowering international long-term bond yields. He also suggests that the impact on foreign bond yields is greater at any time.
He found that declines in 10-year US Treasury yields lead to increases in the share of foreign ownership of emerging market debt. While Q1 resulted in capital outflows for EMEs, Q2 triggered a portfolio rebalancing in the opposite direction pushing capital towards EMEs. Then it became apparent to the central banks that more drastic measures had to be taken to combat mainly the stagnant economy and the inflation that was below the target they had set.
Immediately, the central banks of Europe, the United States, the United Kingdom acted by expanding their balance sheets and thus the monetary base by implementing the so-called quantitative easing (QE). QE allowed central banks to provide liquidity to the market and to ease credit conditions even when interest rates were at the zero lower bound. The various empirical studies indicate that quantitative easing has generally had the desired results as far as asset prices are concerned.
We are not in a position to answer what it would have produced if no quantitative easing had taken place. Even though all four central banks expanded the monetary base with the implementation of QE, none of them managed to significantly increase the broader monetary aggregates.
FED Quantitative Easing Timeline
ECB Quantitative Easing Timeline
THE EMPIRICAL STUDY The analysis
- values in our model
We first consider our model without the impact of quantitative easing (QE). In the second step, we estimate the impact of QE on the variables for the period after 1/1/2009. The estimation in the second step will tell us how statistically significant the QE was.
It is considered a leading indicator in economic cycles and is one of the well-known stock indices. It is a very crucial stage in the economy of the United States and affects the decisions of economic participants. We run these regressions for two periods, one before the introduction of QE and one after the introduction of QE.
In the case of no correlation there is no relationship between changes in the independent variable and changes in the dependent variable. The sign of the regression coefficient will reveal whether there is a positive or negative relationship between the independent and dependent variable. A positive sign in the coefficient reveals how the value of the dependents of.
If we compare the impact of asset purchases on financial variables between two periods, we can safely conclude that the QE program has clearly affected the 1, 2, 5, 10-year maturity spreads and the S&P500. Regarding the S&P500, our model results reaffirm that the implementation of QE has indeed affected the stock market. When using a lower discount rate, investors can expect an increase in the present value of future cash flows, which in turn boosts the stock market.
One of the classic assumptions of ordinary least squares (OLS) is that the observations of the error term are independent of each other. Xt-1 is the value of the variable at period t-1 or "lagged one period" or "lagged X".
Although the lagged dependent variable is used as a method to overcome the autocorrelation model, many studies claim that the lagged dependent variable is sometimes problematic in some situations.
Conclusion
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