On The Transactions Costs Of Quantitative Easing
University of London, Queen Mary – School of Economics and Finance
Bank for International Settlements (BIS) – Monetary and Economic Department
Most quantitative easing programmes primarily involve central banks acquiring government liabilities in return for central bank reserves. In all cases this process is undertaken by purchasing these liabilities in the secondary market rather than directly from the government. Yet the only practical difference between secondary market purchases and bilateral central bank/Treasury operations is the transactions costs involved in market operations. This paper quantifies the significant cost of this round-trip transaction – government issuance of liabilities and then central bank purchase of those liabilities in the secondary market.
On The Transactions Costs Of Quantitative Easing – Introduction: Direct Finance Versus Monetary Financing
Although quantitative easing (QE) programmes vary in design, the four major ones – those of the Bank of England, the Bank of Japan, the European Central Bank and the Federal Reserve – have involved the secondary market purchase of government bonds by the central bank and the associated creation of bank reserves.
Such policies have had two main objectives. The first is to put downward pressure on longer-term interest rates by reducing the average maturity of government debt to sell on the market (ie not held within the central bank). In an open economy, lower domestic interest rates relative to those abroad tend to induce non-residents to sell local bonds (ie capital outflows). The currency depreciates. The second objective is to increase bank reserves and make the domestic banking system more liquid in the hope that bank lending conditions ease. Many studies have shown that quantitative easing has had a large measure of success in meeting these objectives.
The question we ask in this paper is one of implementation: why in all these cases has the government issued debt in the open market for its own central bank to then purchase in the secondary market? Would it not be simpler, and cheaper, for the government to issue the bonds directly to the central bank and avoid round-tripping via the markets?1 This question needs to be asked as central bank reinvestment of maturing government bonds is very large. And it would also be relevant during the exit phase.
Simple macroeconomic theory suggests that the two approaches are identical. The monetary and real effects of official balance sheet policy depend only on changes in the consolidated balance sheet of what used to be called the monetary authorities – that is the government and the central bank combined. Transactions involving only the government and the central bank have no direct effect on the private sector.
The simplest demonstration of this is to suppose the government issues bonds for its central bank to hold and puts the proceeds on deposit with the central bank. The central bank’s balance sheet rises (government bonds as assets and government deposits as a liabilities) but there has been no change in the consolidated balance sheet of the authorities (that is, central bank plus government). It is simply a matter of intra-public sector accounting with no direct economic effects – unless the behaviour of the government or of the central bank is altered (or perceived to be
altered) by this transaction.
It is this qualification – that the behaviour of the public sector entity is not affected by accounting conventions – which is key. Much of the controversy about balance sheet policies revolves around different views about how they could affect government fiscal decisions (eg central bank finance could mean bigger deficits) or central bank policy rate decisions (eg large short-term government debt might force the central bank to set its policy rate too low). In addition, there can be political constraints on governments and central banks that are not captured by the consolidated balance sheet of the authorities (Ueda (2003)).
How has recent quantitative easing changed the consolidated balance sheet of the monetary authorities? Stripped to its essentials, it has changed their liabilities – from long-term government bonds to very short-term bank reserves (i.e. banks’ deposits with the central bank). The effect on this consolidated position of any change in the central bank holdings of government bonds could have been replicated by a comparable change in government debt issuance. Consider the two key objectives mentioned above – lowering the long-term interest rate and expanding bank reserves.
(a) The long-term interest rate. Even assuming expected future short-term rates are given, central bank purchases of longer-dated government paper can drive down the term premium (ie that part of the long-term rate not explained by expected future short-term rates) through portfolio balance effects. quantitative easing has spurred a revival of James Tobin’s work on this mechanism (as well as the old preferred-habitat models, such as Modigliani and Sutch (1967)). Vayanos and Vila (2009) have developed a preferred habitat model to explain the term structure of interest rates. Gertler and Karadi (2013) have established that changes in the term premium play a significant role in US monetary policy transmission. Iwata et al (2016) develop a similar analysis for Japan.
There is hardly anything new in this. Buying long-term government debt was central to Keynes’s analysis in Treatise on Money of how central banks could combat slumps (Tily, (2010)). Worried that a central bank acting alone could run the risk of provoking excessive currency depreciation, he argued that the newly established BIS could encourage internationally coordinated central bank efforts to reduce long-term interest rates. Per Jacobsson, Economic Adviser at the BIS from 1931, strongly supported coordinated policies aimed at reducing long-term interest rates.
The Treasury could achieve exactly the same effects by issuing fewer long-term bonds and more short-term bonds. In the 1930s, HM Treasury was unconvinced by Keynes’s advice, and actually lengthened the maturity of gilts issued. By the mid-1930s, 86% of UK government bonds had a maturity in excess of 15 years. Susan Howson’s (1975) study of British monetary policy in the 1930s found that this limited the effectiveness of the cheap money policy instituted once Britain had left the gold standard: debt management policy ran counter to the monetary policy intent of low short-term rates.
US experience since the 1970s clearly demonstrates how issuing shorter-dated debt lowers long-term interest rates. A recent study over the period 1976 to 2006 (that is, before QE) found that lowering the average maturity of US Treasuries held outside the Federal Reserve – mainly in this period brought about by changes in US Treasury issuance because Federal Reserve purchases were small – reduced the yield of long-term US Treasuries by a significant amount (Chadha et al, 2013).
Since early 2009, the US Treasury’s policy of lengthening the average maturity of gross issuance has worked in the opposite direction as quantitative easing. Larry Summers argued recently that the Federal Reserve’s quantitative easing policies reduced dollar long-term rates by 1.37 percentage points while the increase in the average maturity of Treasury debt issuance added back 0.48 percentage points (Greenwood et al, 2014). Iwata and Fueda-Samikawa (2013) show how the rise in the average maturity of JGBs has at times run counter to the Bank of Japan’s quantitative easing policies.
(b) Expanding bank