Is QE just open market operations on a grand scale?

Published on by chris bowdler

In the last couple of years I have often heard people express the view that quantitative easing (QE) is conventional open market operations, perhaps on an unusually large scale, but otherwise nothing to justify the title 'unconventional monetary policy'. I disagree with this view, here's why.

(1) QE involves asset purchases using newly created cash reserves, i.e. the overall size of the central bank balance sheet is increased. Textbook open market operations (OMOs) intended to vary monetary conditions such as the monetary base or a short-term inter-bank lending rate would entail asset purchases holding constant the overall size of the central bank balance sheet, i.e. purchases of gilts would be funded through disposing of some other central bank asset -- shorter dated bills, foreign currency holdings, gold etc. In other words, traditional OMOs involved shifting the composition of central bank assets towards long maturity assets in order to inject additional liquidity into the banking system. QE is more radical in that new liabilities are created to fund the liquidity injection. The obligation to eventually redeem those liabilities raises the possibility of a future capital loss for the central bank, should the bonds and securities purchased as part of QE lose value. For this reason Parliamentary approval was required for the implementation of QE, since the government will have to cover any capital losses arising from asset trading.

(2) In the US the first phase of QE concentrated on purchases of corporate bonds, mortgage backed securities and other financial instruments, rather than Treasury bonds, the focus of traditional OMOs. As such, QE is consistent with the Fed's policy of qualitative easing in response to the financial crisis, and deviates significantly from classic central bank interventions, in that the central bank plays a direct role in the credit allocation process previously left to the markets, and is exposed to much higher levels of default risk than would be the case for its traditional asset base. These bold steps are, of course, part and parcel of the policies that the Fed thinks will deliver monetary stimulus even when policy rate targets are close to the zero lower bound.

(3) QE is intended to loosen credit conditions for the private sector through stimulating either the traditional banking sector or the shadow banking system comprising markets for equities and corporate debt (many observers contend that only the second route is plausible, but that is a separate story). In order for this to happen, it is important that the policy rate targeted by the central bank is as close to zero as possible. If commercial banks could deposit liquidity injections at the central bank in return for a positive and risk free rate, the incentives to use additional funding for financial intermediation would be stymied. Some observers contend that Bank rate at 0.5% has had a bearing on the macroeconomic consequences of QE in the UK. In contrast, classic OMOs would be undertaken when policy interest rates are far from the lower bound, and could be used as part of a strategy to effect a shift in market interest rates.

Based on these three distinctions, I would argue that QE is more than textbook OMOs and merits the title 'unconventional monetary policy'.

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