Successful central banks focus on greater purchasing power
Interest rates are not a solution for the Japanese and eurozone economies, writes John Greenwood
The Bank of Japan has now been conducting quantitative easing — the buying of financial assets by a central bank — for just over three years, while the European Central Bank has been doing QE for a little more than a year. In neither case have the results been satisfactory — despite interest rates in both Europe and Japan being driven down into negative territory.
Why have these two central banks achieved far less success than either the US Federal Reserve or the Bank of England? Fundamentally, the reason is that interest rates are not a solution to the problems of the Japanese and eurozone economies.
Among the major developed economies — the US, the eurozone, Japan and the UK — two different types of QE have been deployed in recent years. The QE operations conducted by the Fed and the BoE have largely been successful for three reasons. First, because they were targeted at the purchase of securities from non-banks. Second, because they therefore increased the stock of money or purchasing power held by firms and households directly. And third because they were consistent with a reduction in private sector leverage.
To restore economic growth and raise inflation closer to the target of 2 per cent in both Japan and the eurozone, policymakers need to achieve two sets of results. They need to encourage the repair of private sector balance sheets since spending will not resume normal or potential growth rates unless excess leverage is eliminated.
Additionally, liquidity needs to be reinjected into these economies. Or else they should be provided with additional purchasing power, but without adding to leverage.
There are two rules for central banks to follow when designing a QE programme. The first is that the central bank should only buy securities from non-banks. The reason is that the primary purpose of doing QE is — or should be — to expand purchasing power. If the central bank buys securities from banks, there can be no assurance that the money supply will increase. However, if it buys securities from non-banks, this guarantees that new deposits will be created, expanding the money supply.
Of course, if firms or households are deleveraging — repaying debt — the central bank may need to conduct even larger scale asset purchases to counter any reduction of deposits due to the debt repayments.
The second rule is that the central bank should buy only long-term securities. This ensures that the central bank’s portfolio is not rapidly eroded by allowing a high proportion of its securities to mature too soon. As a result the volume of funds injected into the economy can remain stable for a long period of time.
The BoJ has repeatedly broken both these rules, while the ECB has mostly violated the first rule.
Under QE1 and QE2 the Fed purchased treasury securities with maturities as short as two years instead of solely longer-term debt and, consequently, from September 2011 it had to conduct $667bn of what was called “Operation Twist” to unwind this mistake. By contrast, when the Bank of England announced its QE programme in February 2009, it said explicitly that it would buy gilts with longer maturities (5-25 years) precisely so that these purchases would be from non-banks. In doing so it guaranteed the success of its programme.
The fundamental problem is that the ECB and the BoJ are trying to implement QE through the normal credit creation channels of the banking system. But the traditional transmission channels are broken — either because banks are risk-averse and do not wish to lend, or because households and firms are still significantly leveraged and do not want to borrow.
In these circumstances, the policy of relying on ever lower interest rates cannot be assured of success, even if rates are negative. Given that the standard transmission system for monetary policy through the banking system is broken, central banks need to circumvent the banks if they are to create new purchasing power, restore normal economic growth and return to 2 per cent inflation and normal interest rates.
The writer is chief economist at Invesco and a member of the BoE’s shadow Monetary Policy Committee