The short-term interest rate has been the policy instrument of choice for central banks over the past two decades. It has proven to be an efficient and effective tool, with the central bank announcing the desired rate, banks following its lead and the central bank using open market operations to match any residual differences between the ?desired? and ?actual? rate. However, monetary policy management using the short-term rate has one important limitation ? a lower bound of zero. Once the rate touches the floor of zero, lowering it further is practically unfeasible because it implies that the depositor gets a negative return on his investment. Hence, central banks fall into what is termed the ?liquidity trap?, where monetary policy becomes ineffective once short term rates touch zero.
One way of responding to the liquidity trap is quantitative easing, or ?unconventional? monetary policy measures that directly increase money supply or directly manage inflation expectations. These are usually viewed as weaker than interest rate management, as well as potentially inflationary and credibility dampening. However, more and more central banks are adopting this method to combat the liquidity trap in this current crisis, including those of the UK, the US and Japan.
Why is quantitative easing thought to be weaker than interest rate management? The most important reason is signaling. Quantitative easing is usually once-off and unannounced, and can have potentially negative impacts on the credibility of the central bank since it is seen as a departure from its policy reaction function. Similarly, it signals the lack of monetary policy effectiveness via interest rate management, raising crisis alerts among market participants. If proper exit measures are not in place, it could also raise questions as to the length of the expansionary stance of monetary policy, confusing inflation expectations.
Of course, the impacts of different forms of quantitative easing are different. Andre Meier of the International Monetary Fund reviews various forms of quantitative easing in a recent working paper, finding that ?easing via talk?, i.e. making a verbal commitment to lower interest rates for a certain length of time, has significantly different impacts from ?easing via action? or purchasing assets in order to release money supply into the economy.
Meier defines ?easing via talk? as a more generic form of unconventional monetary policy, where the central bank verbally commits to a certain interest rate level in order to manage expectations. However, the effectiveness of this method depends highly on prior credibility of the central bank, and can also have negative impacts on the future credibility of the bank. In contrast, he defines ?easing via action? as more direct interventions, i.e. buying assets to release liquidity into the economy, long-term lending to banks at lower interest rates or helping troubled firms rebalance their portfolios are seen to have extremely stabilizing effects on credit markets. Indeed, these types of measures are being taken at this moment by both the Federal Reserve and the Bank of England, in order to counter the credit crisis. However, he argues that this carries with it the risk of inflating the balance sheet of the central bank. For example, the balance sheet of the Fed has inflated tremendously over the past year, with net assets ballooning to over 2 trillion dollars in July 2009 from 900 billion dollars in July 2008.
Finally, it is clear that there are political risks to quantitative easing, which hold across both easing via talk and action. Unconventional monetary policy actions, especially with a view to stabilizing the financial sector, push the central bank into politically sensitive areas such as deciding which firms to bailout. Similarly, the risk of fiscal capture, with the government using expansionary monetary policy to finance debt is another major political risk.
The author lives and works in Singapore. These are her personal views.