Quantitative Easing By Henry C.K. Liu Part I:  Quantitative Easing is not Automatically A Keynesian Measure Part II: The Debate on Negative Interest rates In late May 2013, in the midst of a critical government debt crisis in eurozone member nations who have surrendered their monetary sovereignty to the European Central Bank (ECB), whose Chairman, Mario Draghi triggered a public debate on whether ECB should permit negative interest rate as a frantic policy mechanism to stop the euro from further rise in exchange value against the dollar and the yen by default. This would shift the pain of euro-denominated deflation from banks to depositors, and from debtors to creditors, and from borrowers to lenders.   Negative interest rates are ultimate market distortions, being punitive to depositors without redeeming value of incentivizing banks to lend to a dwindling number of systemically significant market participants who still seek loans in a stalled overleveraged market to enhance thin profitability through higher leverage. An ECB-condoned negative interest rates regime would invite eurozone banks to hoard euro deposits simply to collect interest from depositors rather than having to lend out deposit funds to collect interest from borrowers. This practice will turn bank deposits into idle funds sitting on the sideline of a lackluster financial market to hope to profit from foreign exchange arbitrage rather than as active lending to finance new business activities to kick start a stalled economy in which windows of profitability are nearly totally shut. The effectiveness of the benchmark rate set by central bank targets to stimulate bank lending is drained as it approaches zero and cannot be lowered further through central bank open market operations to stimulate more economic activities. This is because negative interest rates cause depositors to pay interest to the deposit-taking bank for the privilege of depositing money with the bank. That abnormal arrangement can reduce the bank's incentive to put deposits to work by taking manageable risk in lending to earn returns on deposits above interest paid to depositors. The spread between interest paid on deposits and return on investment using deposits is the profit made by banks. Negative interest rates cause creditors (deposit-makers), to pay debtors (depositing-taking banks) for the privilege of letting the borrowers use the lenders' money - an arrangement that violates the fundamental principle of finance. Negative interest rates allow borrowers to profit by simply sitting with idle money on which lenders pay borrowers interest. Such arrangement is a peculiar method in the  madness of distorted macroeconomics when market participants expect money to rise in purchasing power over a sustained period of secular price-deflation in which each subsequent price decline is steeper than the previous rebound, or when deposits are denominated in a currency that is expected to rise in exchange value over time in relation to the reserve currency in international trade, costing the deposit-taking bank to suffer financial loss as depositors withdraw money with more purchasing power or higher exchange value than money deposited earlier and the spread between interest on loans and interest on deposits is less than the operating cost of banks. Such modi operandi are clear symptoms of impending financial disaster to the banking system and impending liquidity crisis to financial markets. The benchmark short-term inter-bank interest rate set by central banks to manage bank lending in the financial system is known in the US as Fed funds rate (FFR). While the FFR target is set by fiat by the Federal Reserve Board, the process of hitting the target is done by Fed open market operation through the repo (repurchase agreement) market. A repo is a sale and repurchase agreement of securities, usually of top rating, together with an agreement for the seller to buy back the securities at a later date, usually of short duration. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their top-rated securities as collateral for a secured cash loan at a fixed rate of interest for a fixed period. A repo contract is equivalent to a spot sale combined with a forward contract. The spot sale results in transfer of money to the borrower in exchange for legal transfer of the collateral security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan, while the settlement date of the forward contract is the maturity date of the loan. A key aspect of repos is that they are legally recognized as a stand-alone single transaction (important in the event of counterparty insolvency because the transaction legally predates bankruptcy proceedings) and not as a disposal and a repurchase for tax purposes in which the lender is merely a secure creditor to the bankrupt party under court protection. When used by the Fed, repos add reserves to the banking system and then after a specified period of time withdraws them. Reverse repos initially drain reserves from the banking system and later add them back. This tool can also be used by the Fed to stabilize interest rates to adjust the Federal funds rate to match its target rate. Under a repurchase agreement, the Fed buys US Treasury securities, US agency securities, or mortgage-backed securities from a primary dealer who agrees to buy them back, typically within one to seven days. A reverse repo involves an opposite flow. Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint. If the Fed is one of the transacting parties, the repo is called a "system repo", but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a "customer repo". Until 2003 the Fed did not use the term "reverse repo"—which it believed implied that it was borrowing money (which is counter to its charter: the Fed can create money but has no authority to borrow money, which belongs only to the Treasury)—but used the term "matched sale" instead. Targeting a negative FFR would turn the repo market into Alice in Wonderland. In the US, during the 2008 global financial crisis, the Bank of New York imposed a negative interest rate – a penalty – on deposits over $50 million, essentially telling depositors to withdraw their money from the bank because it could not find credit worthy borrowers. In 2011, Swiss National Bank, the central bank, lowered its interest rates to near zero in order to keep the exchange value of Swiss franc from rising. Later, it imposed a floor of 1.2 Swiss francs per euro to stop the appreciation of the Swiss franc in order to help Swiss exporters remain competitive. Swiss banks were not the first banks to opt for negative interest rate policy. In October 2012, State Street Corporation and The Bank of New York Mellon Corporation imposed a fee on depositors for holding Danish kroner and Swiss francs deposits. This move was a part of these banks’ strategy to re-establish a decent profit margin between what had been paid as interest on deposits and what had been earned on investments with deposits. As the Euro Zone crisis deepens, investors have started drifting to other safer currencies as they desert the volatile Euro. European nations, such as Denmark and Switzerland, have slashed interest rates below zero levels to stop their currencies from rising. reflecting the fact that currencies like the Swiss francs and Danish kroner involve lower risk than the Euro. While negative interest rates discouraged big institutional clients from stashing more deposits into the banks, thereby increasing active money supply in the market, protecting the Swiss economy from deflationary pressures, the incentive of banks making more loans to cover payment of interest on deposit is neutralized by negative interest revenue from deposits. Banks were making profit without lending out deposits. Swiss authorities imposed a negative interest rate regime when the Swiss franc was faced with upward pressure in currency markets during 1977–78. Small, open economies with sound monetary arrangements are vulnerable to unwelcome speculative inflows whenever the currency to which they are pegged experiences a prolonged episode of weakness. There is need for interest rate flexibility beyond zero in the smaller economy to absorb such pressures to prevent inflows from being permanently disruptive. The flexibility was an interim attempt to deal with some of the side-effects of speculative pressure on the Hong Kong dollar before the introduction of the new “accounting arrangements” in July 1988 that gave the authorities more direct control over the money markets and more influence on the spot rate. The negative interest rate regime was significant but ultimately of second-order importance in the restoration of market confidence in Hong Kong's currency board which pegs the HK dollar to US dollar at a fixed rate. Hong Kong banks introduced similar negative interest rates on US dollar deposits during the 1997 Asian Financial Crisis when its Linked Exchange Rate System, (the peg), fixing the Hong Kong dollar to the US dollar was under attack by currency traders in London. The negative interest rate was designed to compensate Hong Kong banks for the trend of US dollar deposits rising in value against the HK dollar at withdrawal in future time. Following anti-recession cuts in US interest rates in 2008 by the Fed, negative real interest rates became an issue of considerable interest among banking circles in Hong Kong due to its highly externally oriented economy, the three largest trading partners of which are Mainland China, the EU and the US. As a result, inflation trend in Hong Kong tends to track those of its trading partners which since 2007 has been tame relative to historical norms. US monetary policy, which is set by the Federal Reserve in response to US needs, to which Hong Kong is a captive follower through its currency peg, is often not appropriate for Hong Kong's needs. This is particularly true as the US sub-prime mortgage crisis that began in 2007 impacted different economies in different ways around the world.  With higher inflation pressure from China and relatively strong performance of the Hong Kong economy, Hong Kong should avoid negative interest rates; but the currency peg to  the US dollar gave Hong Kong little room to keep Hong Kong Interbank Offering Rate (HIBOR) above London Interbank Lending Rate (LIBOR) and FFR. Both the Federal Reserve and the ECB Interest rates adopted a near zero benchmark interest rate in response to the protracted severe recession. While because of the currency peg, Hong Kong is prevented from decoupling its monetary policy from the stimulant stance adopted by the Federal Reserve, and at the same time Chinese authorities are trying to cool the overheated Chinese economy, with EU economies are being forced by the IMF to adopt punitive austerity measures as "conditionalities" for bailing out the eurozone banking system,  Hong Kong is caught between a monetary rock and a fiscal hard place dilemma that presents risks in the long-term outlook for Hong Kong’s economy, especially in the property sector that has been exhibiting classic symptoms of a price bubble that historically had been rescued by inflation. There are two dimensions to the impact of negative interest rate on Hong Kong's fully trade-dependent economy. The first is if interest rates on deposits are lower than the rate of consumer and asset price inflation, consumption will be favored over saving, as consumers and speculators rush to acquire goods and assets with low interest loans that can be paid back with money with lower value. This would then lead to even higher inflation rate, at least in the non-traded-goods sector. This may create a price bubble that will eventually affect economic and financial stability in the Hong Kong economy. But a spending and acquisition boom fueled by negative interest rate will soon produce a liquidity drought to bring about a market in which cash will be king, stalling the economy  in which while prices remain high, transaction in the market stalls for lack of liquidity.   The second dimension is the phenomenon of mortgage interest rates being lower than the rate of increase in residential property prices. When the mortgage rate is at 2.75% and the expected annual rate of increase in residential property prices is much higher, home buying will accelerate to capture the spread. But the history of the past 3 decades shows that in Hong Kong, real mortgage interest rates, defined as the nominal mortgage interest rate adjusted by the expected rate of property price appreciation in the following year, have been very volatile – in some periods (for example, in late 1997 when real mortgage interest rates were substantially above price inflation rate as property value plummeted in the political uncertainty of the return of Hong Kong to China, and in 2002 when property prices skyrocketed to the long time gap for inelastic supply to meet sharp sudden rise in speculative demand in housing. A negative real interest-rate market greatly increases economic and financial instability. Hong Kong bond yields in 2013 are trailing inflation by the most on record, spurring demand for yuan- denominated assets as China adopts measures that make it easier for Hong Kong residents to invest in securities on the Mainland. The yield on Hong Kong’s two-year government debt fell to a record 0.16% in 2012, from 0.64% at the start of 2011. That’s 5.44 percentage points less than 2012 inflation rate of 5.6%, the biggest gap shown in Bloomberg data going back to March 1998. Hong Kong's Ten-year yields fell 121 basis points in 2012 to 1.66%. China’s 10-year yield rose four basis points to 3.89%. The Hong Kong dollar is pegged to the US dollar, which dropped 3.1% percent against the RMB yuan in 2012. RMB yuan deposits in Hong Kong jumped six-fold in 2012 through June and grew further after China bolstered the amount of debt Chinese companies sold in Hong Kong in 2013 and eased limits for Hong Kong investors on buying securities in Shanghai and Shenzhen. Hong Kong investors are seeking to preserve their capital in real property at a time when global recovery jitters are pummeling stocks worldwide since 2008, pushing real estate prices up. Barclays Plc predicts Hong Kong home prices will slide as much as 30% by the end of 2013. Yuan deposits in Hong Kong jumped six-fold in 2013 through June and investment options are growing after China in the last week of June 2013 sold yuan debt in Hong Kong and eased limits on buying securities in Shanghai and Shenzhen. The yuan is a very stable currency with steady gains as the credit quality of China’s sovereign debt remains solid. In Sweden, Sveriges Riksbank, the central bank, also attempted negative interest rate stance during the Eurozone sovereign debt crisis but quickly reversed its policy as a positive cost/benefits outcome from negative interest rates was not ensured. It is unlikely Sweden would resort to using negative interest rate again soon. In the US, the current near zero but still positive interest rate is in reality negative interest rate, being solidly below inflation rate by 175 basis points. The Federal Deposit Insurance Corporation (FDIC) charges a fee assessed on assets of US-based deposit-taking institutions. FDIC fee is calculated on excess reserve deposits at the Federal Reserve, on which the Fed pays an interest rate of 25 basis points, or 0.25 percent. The differential between the excess reserve positive rate and Fed fund rate (FFR) reflects a market that is attempting to find a clearing price of overnight liquidity transacted among and between banks. The FFR is set below the excess reserve rate set by market forces. Another market distortion occurs in the US because Fannie Mae, Freddie Mac, and other Government-Sponsored Enterprises (GSEs) do not participate directly with reserve deposits at the Fed. Fannie Mae is not a bank; it has to sell its excess cash in the federal funds market at whatever interest rate it can obtain. That is how it earns something other than zero on its large excess cash flows. Buyers of Fannie Mae federal funds recycle the funds to the Fed as an excess reserve deposit. Buyers make an arbitrage profit less the cost that they incur in payments of the FDIC fee. The whole process in the US is even further distorted by the fact that US subsidiaries of foreign-owned banks are not subjected to the FDIC fee and operate with a different formula than US banks. The principle behind that rule is that the capital determinants of foreign banks are set by a different regime than for US banks. This distortion at the short end of the yield curve in these near zero interest rate times exacerbates difficulties in the formulation and implementation of monetary policy. In the midst of all this turbulence in the market, the ECB has set off a trial balloon with an unsettling debate on negative interest rates attached to it. In recent time, negative interest rates have been used with mixed results by banks under unusual dysfunctional economic conditions. Swiss banks tried to discourage incoming CHF deposits by imposing negative interest rates on CHF deposit balances placed with Swiss banks, to compensate for the difficulty Swiss banks faced in finding credit-worthy risk-averse borrowers in a recession in which the CHF as a fully convertible currency was rising in exchange value. The largest Swiss banks, including Credit Suisse Group, faced with a loss of CHF5.5 billion ($5.6 billion) in Q4 2008 and a loss of CHF8.2 billion ($8.7 billion) for the whole year; and UBS AG, with a loss of US $22.2 billion in 2008, both primarily from ill-fated securitized sub-prime mortgage operations, decided in December 2012 to charge fees and negative interest rates on interbank CHF deposits. This action was motivated by a desire to discourage excess hoarding of the preferred currency with rising exchange value. Credit Suisse was the first bank to set negative interest rates on CHF deposits in response to rising demand for the increasingly strong Swiss currency against the euro and the dollar. The bank started implementing negative interest rates from December 10, 2012. However, only inter-bank deposits were subjected to negative interest rates whereas deposits of individuals were spared. Similarly, UBS AG took the position that charging a fee on excess CHF deposit would help it maintain multi-currency account balances at optimum levels. Operating in more than 50 countries with about 63,500 employees globally, UBS AG was the world's largest manager of private wealth assets, with over CHF2.2 trillion in invested assets, a leading provider of retail banking and commercial banking services in Switzerland. The Debate on Inflation Targeting   Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate needed for the good of the economy and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools. Central bankers hold different views about the need and effectiveness of inflation targeting. Fed policy under Alan Greenspan did not include inflation targeting while Fed policy under Ben S. Bernanke includes inflation targeting. It is not known what Janet Yellen stands on the issue will be as Fed Chair. As Fed Vice Chair, Janet Yellen said on April 4, 2013 the Federal Reserve should focus its energies on bringing down an elevated U.S. unemployment rate even if inflation "slightly" exceeds the central bank's target, adding she looks forward to the day when policymakers can abandon unconventional tools like asset purchases and return to the conventional business of lowering and raising interest rates, currently set at effectively zero. But Yellen made that clear that time is not near, saying eventual "normalization" of policy by the Federal Open Market Committee is still far in the future. "Progress on reducing unemployment should take center stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding 2%," Yellen told a meeting sponsored by the Society of American Business Writers and Editors. She said she favored adjusting the pace of Fed QE bond purchases, currently running at $85 billion a month, in response to changes in economic conditions. At the time, the U.S. economy showed signs of strength in the first quarter, with many economists predicting an annualized growth rate above 3%. The economy generated 236,000 jobs in February, while the jobless rate fell to 7.7%. At the time, Yellen said an eventual end to the central bank's bond-buying stimulus will not mean interest rate increases are imminent, stressing the weak nature of the recent economic recovery. "Adjusting the pace of asset purchases in response to the evolution of the outlook for the labor market will provide the public with information regarding the committee's intentions and should reduce the risk of misunderstanding and market disruption as the conclusion of the program draws closer," she said. Asked about Japan's announcement of a massive $1.4 trillion monetary stimulus overnight, Yellen suggested it was appropriate for the central bank to take steps to fight a prolonged bout of deflation. "Taking an aggressive approach to try to end deflation is something I certainly understand," she said, adding: "What Japan is doing is something that's in their own best interest, it's something that if successful will be good for stimulating growth in the global economy and it will be good for us too." Inflation targeting is a Fed policy of announcing what it thinks is the optimum inflation rate, and then taking monetary measures to achieve the target rate. The Fed sets and publicizes a target goal for the inflation rate -- conventionally set at 2% a year. The Fed makes public its best estimate of the expected inflation rate in the coming year. It then conducts monetary policy measures to try to adjust the inflation rate to hit the target set by it. If expected inflation is higher than the target, the Fed would raise interest rates to cool the economy and bring inflation back down to target. If expected inflation falls below the target rate, the Fed would lower interest rates to stimulate growth to raise the inflation rate to target. Inflation targeting is part of the official monetary policy of Britain, Canada, Australia, Sweden, New Zealand, Brazil, and South Korea, among others. A Goldman Sachs study in June 2005 showed that countries that implemented inflation-targeting monetary policies tended to stabilize their inflation rates while keeping economic growth steady. The study found that the US and Japan, which did not set formal inflation targets, have more volatile stock and bond markets -- reflecting investor uncertainty about the direction of inflation. Bernanke vs Greenspan on Inflation Targeting Bernanke favors inflation targeting because he thinks that a more "transparent" Federal Reserve policy would promote stable, noninflationary economic growth by giving businesses and consumers more certainty about the future course of interest rates and inflation. Transparency is always supported by incoming Chair Janet Yellen. Greenspan was against inflation targeting because he thought the Fed can control inflation without announcing a target rate. Also, he worried that an announced rate would make it harder for the Fed to respond flexibly and intuitively to a financial crisis or changing economic conditions. Greenspan recognized from a variety of subtle indicators in 1997 that rapid productivity growth was likely to curb inflation -- even though most conventional forecasts predicted accelerating inflation. He persuaded fellow Fed policymakers to not raise interest rates, allowing the economy to flourish. Bernanke rejects that argument that inflation targeting would decrease the Fed's policy flexibility, arguing that in a crisis the Fed should do whatever it takes to stabilize the economy. Frederic Mishkin, a Columbia University economist and longtime Bernanke collaborator, says that establishing credibility with the financial markets as an inflation hawk gives an inflation-targeting central bank more, not less, flexibility to tackle recessions. Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. For example: if inflation appears to be above the target, the Fed is likely to raise interest rates. This usually (but not always) has the effect over time of cooling the economy and bringing down inflation. if inflation appears to be below the target, the Fed is likely to lower interest rates. This usually (again, not always) has the effect over time of accelerating the economy and raising inflation. Under the policy of inflation targeting, market participants know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This rational expectation is viewed by inflation targeters as leading to increased economic stability. The Fed policy setting committee, the FOMC (Federal Open Market Committee) and its members, regularly publicly state a desired target range for inflation (usually 1.7%-2%), but do not have an explicit inflation target. In a historic shift on January 25, 2012 Chairman Ben Bernanke set a 2% target inflation rate which brings the Fed in line with many of the world's other major central banks. This is likely to be seen as a positive step for the Fed as inflation targeting is usually very successful in other countries because of its transparency and predictability to market participants. However, some counter that an inflation target would give the Fed too little flexibility to stabilize growth and/or employment in the event of an external economic shock, defined as an unpredictable change in exogenous (outside the system) factors—that is, factors unexplained by conventional economic concepts—which may have an impact on endogenous (within the system) economic variables which elicit impulse response functions on economic variables such as output and employment at the time of the shock and at subsequent times. October 24, 2913 Next: Schism in Macroeconomics