effective and essential response to lender-side problems, such as a financial crisis, but can do relatively little to address the borrower-side problems seen in a balance sheet recession.
Richard Koo: Conclusion: difficult to determine impact of quantitative easing
The report claims that quantitative easing has had some macroeconomic impact, but says it is difficult to determine precisely how large an impact since a lack of data makes it impossible to estimate the base-line scenario (with no quantitative easing) using the Fund’s econometric models.
I think the IMF’s acknowledgment that it cannot provide a base-line scenario and therefore cannot estimate the impact of quantitative easing represents progress, but the report does not attempt to analyze why the economy did not improve when central banks took rates down to zero or why central banks were forced to engage in quantitative easing in the first place.
In that sense, I do not think the IMF fully understands the importance of the fact that these countries are in balance sheet recessions, with private-sector borrowers paying down debt in spite of zero interest rates. This lack of understanding is also underlined by the following passage: “A key concern is that monetary policy is called on to do too much, and that the breathing space it offers is not used to engage in needed fiscal, structural, and financial sector reforms.”
Conventional monetary policy has lost its effectiveness because private-sector borrowers are no longer borrowing in spite of zero interest rates. If the government renounces its role as “borrower of last resort” under fiscal reform at a time when the private sector is also not borrowing money, GDP and the money supply can spiral downward in a repeat of the Great Depression of the 1930s. Unfortunately, the IMF researchers who demanded fiscal reform in this report seem unaware of this risk.
Richard Koo: Exit from quantitative easing likely to be a bumpy ride
Be that as it may, the report’s central argument is that the exit from quantitative easing is likely to be a bumpy ride. The IMF economists even estimated the extent of central bank losses on government bond holdings in the event of a normalization of economic conditions.
For example, they estimate that an event similar to 1993–94, when the Fed began normalizing monetary policy by raising the policy rate from a starting level of 3%, would generate central bank losses equal to 2.0–4.3% of GDP in Japan, the US, and the UK.
These represent capital losses on the government bond portfolios of the central banks that are likely to result when interest rates normalize, sending bond prices sharply lower. These losses also represent a one-time fiscal burden on the governments involved, since they reduce the central bank’s payments to the government and hence the government’s revenues for that year.
Richard Koo: BOJ losses could climb to 7.5% GDP in worst-case scenario
In 1994 the Greenspan Fed raised the federal funds rate from 3%, then a postwar low, to 4.5%, which pushed the 10-year Treasury yield 200bp higher in what was described as a “bloodbath” in the bond market.
Today, the central banks must not only raise short-term interest rates but also mop up excess reserves amounting to 16.3x and 9.9x statutory reserves in the US and UK, respectively. Moreover, the only assets central banks can sell to absorb those reserves are long-term government bonds. This process will almost certainly be a difficult one for long-term bond markets in all of these countries. Although the excess-to-statutory reserve ratio currently stands at about 5x in Japan, it will rise to 18.7x if the BOJ’s new easing program is carried through to completion.
The IMF report also contains estimates of what would happen in the event that central banks’ exit strategies failed, triggering a loss of confidence in the central banks and their currencies. In Japan, where the central bank is attempting the most aggressive quantitative easing program of any of the three countries, the IMF estimates that losses would rise to 7.5% of GDP.
This amount would be added to the Japanese government’s already severe fiscal deficits and could potentially create a serious fiscal problem for the country.
Richard Koo: Emphasis needs to shift quickly from monetary policy to fiscal policy and growth strategy
The IMF defines a “failed” exit strategy as a delay in the removal of the policy that leaves the authorities behind the curve. This kind of situation can be avoided by bringing quantitative easing to an early conclusion. In Japan’s case, doing so could also reduce the possibility of a “bad” rise in interest rates emerging first.
With even the IMF declaring that countries with quantitative easing programs have a bumpy ride ahead as they seek to navigate an exit, the Japanese government needs to shift the focus of its economic strategy as quickly as possible from monetary policy to the second and third elements of Abenomics. The US and the UK also face similar challenges.
Richard Koo: Quantitative easing: easy to start, scary to end
The scale of the potential losses suggests that quantitative easing, while easy to initiate, can be scary to bring to an end. It is therefore important that the authorities move quickly and decisively to ensure they do not fall behind the curve.
The first round of quantitative easing at the Fed (QE1) was similar to the Bank of Japan’s quantitative easing program from 2001 to 2006 in that all operations were conducted in the short-term money market, making them easy to wind down.
The dismantling of Japan’s quantitative easing program in 2006 therefore went surprisingly smoothly. However, the Fed’s subsequent QE2 and QE3 and Japan’s recently announced “new dimension” of easing are conducted with long-term government bonds. This has the potential to create a great deal of turmoil in the market, as the IMF notes, when the programs are discontinued.
I think it is important that Japan quickly prepare the second and third elements of the economic program, reduce the dependence of its economy and markets on monetary accommodation, and create an environment conducive to the dismantling of quantitative easing so as not to fall behind the curve. The same can be said of the US and the UK.
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