-- John Kemp is a Reuters columnist. The opinions expressed are
his own --
By John Kemp
LONDON Jan 14 Fed Chairman Ben Bernanke's
speech yesterday was the most detailed explanation to date of
the "alternative" monetary policies the central bank has been
implementing since last autumn. In it he set out a defence of
the technique, sought to rebut criticism it would lead to higher
inflation in future, and set out an exit strategy for returning
to more conventional methods of monetary control when conditions
Bernanke was particularly anxious to reject comparisons
between the current strategy and the quantitative easing pursued
by the Bank of Japan in the late 1990s, and which he himself
foreshadowed in a now famous speech given in 2004. Bernanke
prefers to characterise the Fed's current strategy as credit
easing (CE) rather than quantitative easing (QE).
QUANTITATIVE EASING, JAPAN
The Bank of Japan's quantitative strategy was a response to
the relatively straightforward problem of deflation in both
asset prices and the price of goods and services. QE was
explicitly designed to generate a higher (positive) rate of
inflation. Since interest rates had already been cut close to
zero, the bank tried to increase inflation by raising the
quantity of money in circulation.
It began to define the operational target for monetary
policy in terms of the quantity of reserves commercial banks
held at the central bank, rather short-term interest rates.
Ultimately the Bank of Japan hoped excess monetary growth would
trickle through to increases in real activity and more
importantly a higher rate of inflation.
Crucially, the Bank of Japan set its target in terms of the
quantity of reserves, which show up on the liability side of the
central bank's balance sheet. To create them, the Bank of Japan
bought a wide range of assets from the banking system via open
market operations, which expanded the asset side of its balance
sheet as well.
But Bernanke's point is that the asset purchases were
incidental to the strategy. The Bank of Japan was focused on the
volume of reserves (the liability side) and fairly indifferent
to the type of instruments it was purchasing (adding to the
It focused on the quantity of reserves rather than the type
of assets it was buying because it was trying to counter a
general problem of deflation by raising the total volume of
money in the economy. Banks themselves could be left to decide
where to extend additional loans. Extra credit would be
allocated throughout the economy via normal market mechanisms,
with interest arbitrage ensuring credit ended up where it could
be used most efficiently and brought the highest return.
CREDIT EASING, UNITED STATES
In contrast, Bernanke argues the Fed's strategy is more
nuanced. It focuses on buying specific types of securities in
the open market (adding them to the asset side of the balance
sheet). The fact many are bought directly from the commercial
banks, resulting in an increase in the volume of excess reserves
they hold with the central bank (expanding the liability side of
its balance sheet) is incidental. Increasing bank reserves is a
side effect of the Fed's policy, not the central aim.
The Bank of Japan responded to a deflation problem by
expanding the size of its balance sheet; the Fed is responding
to a credit crisis by changing the balance sheet's composition.
Unlike the Bank of Japan, the Fed is more concerned about
the disappearance of credit to certain types of borrowers. By
buying certain classes of assets in highly targeted operations,
the Fed hopes to restore liquidity and get markets operating
Bernanke conceded that the crisis facing the Fed is in many
ways worse than that which faced the Bank of Japan. Because some
credit markets have essentially disappeared, the Fed cannot rely
on normal market mechanisms and interest arbitrage to ensure
that extra funds end up where they are most needed. It has to
direct liquidity to specific sectors of the economy, rather like
a central planner, rather than just adding general reserves and
waiting for the banks to direct credit to the most-needy
It is this highly targeted and discriminatory approach that
caused Stanford economist John Taylor to complain the Fed was
running a monetary-industrial ("monindustrial") policy. In a
stinging critique that seems to have wounded senior Fed
officials, Taylor argued the Fed was usurping the function of
the market. It should instead use a more neutral mechanism and
leave the market to allocate the extra funds.
Bernanke clearly believes a neutral policy will not work
because some markets have broken down for the time being.
Because the Fed's strategy is focused on adding liquidity to
very specific parts of the market, Bernanke prefers to
characterise it as credit easing rather than quantitative
VELOCITY, EXIT AND INFLATION
While there are important but subtle differences between QE
and CE, the eventual impact on inflation could be the same,
which is why the Fed is so keen to downplay comparisons with the
Bank of Japan's earlier programme or Bernanke's "helicopter"
The Fed is caught in a dilemma. Public and business
confidence in the eventual effectiveness of monetary and fiscal
responses is crucial to restarting lending markets and economic
growth. So the Fed is not anxious for its own CE strategy to be
compared with the relatively ineffective QE strategy pursued by
the Bank of Japan in the late 1990s and early 2000s.
But the market's real fear, one that the Fed is anxious to
downplay, is the policy will eventually work only too well.
Conventional monetary theory (MV=PT) says that for a given level
of demand for liquidity (velocity, V), increases in the money
supply (M) are expressed as an increase in real output
(transactions, T), the price level (P), or some combination of
Deliberately or not, the Fed's CE strategy is increasing the
level of commercial bank reserves, which are the most potent
component of the monetary base (M). Many commentators have
expressed concern this massive monetary expansion must
eventually spark an upsurge in inflation once the economy begins
Bernanke counters that the current increase in the monetary
base (M) is being offset by a corresponding rise in the demand
to hold liquid instruments (a decline in V) so there is no
current impact on inflation.
Once the crisis passes, demand for liquidity should fall (V
will rise). At this point, the extra bank reserves could indeed
become inflationary. But Bernanke argues it would be a
relatively simple matter to begin withdrawing them.
Much of the liquidity has been created by buying assets with
a short maturity (such as commercial paper) which could simply
be allowed to run off. Liquidity added by buying longer-dated
assets could be absorbed by selling more government debt to the
LIQUIDITY WITHDRAWAL SCHEDULE
This is much too optimistic. Confidence (V) is notoriously
volatile and hard to forecast. Once the economy starts to
stabilise and confidence returns, demand for liquidity could
fall swiftly and the same quantity of excess reserves could
quickly become inflationary. At that point volumes rather than
intentions will matter more; targeted CE measures would
effectively become generally inflationary QE ones.
The Fed would have to match the return of confidence with an
equally nimble withdrawal of excess reserves. But past
experience suggests the Fed finds it hard to withdraw liquidity
promptly once a crisis has passed. There is no reason to think
the central bank would be any more successful this time.
Just the sheer multiplication of monetary policy instruments
has made the decision-making process much harder. The Federal
Open Market Committee experienced enough difficulty running an
effective monetary policy in the late 1990s and early 2000s when
all the FOMC members had to worry about was setting a single
target interest rate, and arguably got it badly wrong.
The idea the Fed will be able to manage a plethora of CE/QE
programmes to withdraw liquidity promptly and in a carefully
calibrated manner to avoid an uptick in inflation requires a big
leap of faith.