Fed embarks upon quantitative easing

Lagos / AFP

Investors won’t necessarily be surprised if the Federal Reserve embarks upon another edition of quantitative easing when the next US recession hits. What would come as a shock is if the central bank decided to purchase assets before exhausting its more traditional form of accommodation: rate cuts.
But that approach might be just what the doctor ordered, according to a new paper from Columbia University Professor Michael Woodford. He argues that balance sheet expansion buoys economic activity, but it also poses fewer risks to financial stability than rate cuts or the relaxation of
macroprudential constraints.
“Quantitative easing policies increase financial stability risk, but they actually increase such risk less than either of the other two policies, relative to the magnitude of aggregate demand stimulus,” the professor writes.
The global financial crisis — which was, at the most basic level, a series of funding crises — heavily informs Woodford’s view of what constitutes a risk to financial stability.
Under the framework of his model, central bank policy actions that incent the issuance of short-term debt by financial intermediaries to engage in liquidity and maturity transformation increase the risks to financial stability.
“Conventional monetary policy, which cuts short-term nominal interest rates in response to an aggregate demand shortfall, can arguably exacerbate this problem, as low market yields on short-term safe instruments will further increase the incentive for private issuance of liabilities of this kind,” he writes.
Under normal conditions, if a bank sees an increase in reserves, its ability to issue short-term paper also rises. But this isn’t a constraint that banks have faced since the end of 2008, Woodford says. As such, quantitative easing tends to make the issuance of short-term paper less attractive to banks in an environment in which
reserves are abundant.
Asset purchases reduce the premium financial institutions can realize by issuing this money-like short-term debt by boosting the supply of deposits, which also reduces the need for banks to rely upon that source of funding.
Nor does the suppression of risk premia — the extra return investors demand for owning a riskier asset — entail that banks are going to put themselves in a precarious position because central bank purchases have
distorted their perception of risk.
“To the contrary, the existence of a smaller spread between the expected return on risky assets and the risk-free rate makes it less tempting to finance purchases of risky assets by issuing safe, highly liquid short-term liabilities that need pay only the riskless rate,” writes Woodford.
The professor’s analysis suggests that quantitative easing offers a better risk/reward proposition for a central bank that wants to bolster economic activity but is also concerned about risks to financial stability.