Reserves and reservations - Japan’s QE redux

Posted by Tracy Alloway on Dec 01 09:10.

Here’s a question worth answering in light of the Bank of Japan’s consideration of Round Two of Quantitative Easing.
Are bank reserves — the things which QE increases — in any way special?
Claudio Borio and Piti Disyatat don’t think so. In a BIS working paper entitled “Unconventional monetary policies: an appraisal” they write:
. . . the general point stands: focusing on the specialness of reserves in balance sheet policy is misplaced. The point can be seen another way. What makes bank reserves special when implementing interest rate policy is the combination of their remuneration at a rate set exogenously below market rates (be this zero or positive) and their settlement services. This makes bank reserves powerful and unique: the implied highly inelastic demand curve is what obliges the central bank to meet the small demand for (excess) reserves very precisely, in order to avoid unwarranted extreme volatility in the rate (scheme 1). But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets (scheme 2). In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the public sector. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors.
Which rather casts doubt, according to the authors, on two of the central propositions concerning the specialness of bank reserves. First, that expanding them gives banks additional resources to extend loans. And secondly, that there is something uniquely inflationary about bank reserves financing.
On the first point — and getting back to the Japan theme:
A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.
To be clear: this is not to say that central banks are powerless to influence bank lending. In situations where lending is initially limited by significant funding constraints at the bank level — either because of illiquid assets or inability to borrow — interventions that alleviate this will facilitate lending. Thus, contrary to the popular assertion that injections of excess reserves into the banking system are ineffective when the bank lending channel or money multiplier is “broken”, it is precisely in such situations that the likelihood of their having any significant impact is greatest. But the underlying mechanism is supplying banks with a liquid asset that liquefies their balance sheets at a time when the market is not prepared to do so. Reserves simply constitute one possible asset among the many that can serve this purpose.
And on the second point:
The proposition that highlights the inflationary consequences of financing via bank reserves is closely related to the first. If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be. The impact on aggregate demand, and hence inflation, would be very similar regardless of how the central bank chooses to fund balance sheet policy. For example, it is not clear how inflationary pressures could be more pronounced in a banking system that keeps its liquid assets in the form of overnight deposits at the central bank compared to one that holds one-week central bank or treasury bills.
. . .
There is, however, one important qualification to our analysis so far. This has implicitly treated market expectations and beliefs as consistent with the underlying transmission mechanism. But views about the workings of the economy differ and are a key driver of economic outcomes. And this can complicate the transmission of policy. For example, what if economic agents do believe - as argued here, incorrectly - that bank reserves are truly special? We briefly discuss some of these complications in the next section, where we explore selectively some specific challenges raised by balance sheet policy.
Which we think means that market expectations of impending inflation could end up threatening some of the efficacy of the unconventional policy measure — even if bank reserves themselves aren’t intrinsically inflationary. Communication is thus one of the major QE challenges facing central banks, the authors say.
But so — crucially — is calibrating an exit strategy:
The main concern surrounding [unconventional monetary policu] exit policies, however, is not technical, but one of timing: can the timing and pace of the exit be properly judged? This concern is a familiar one, as it also applies to interest rate policy. One possibility is that exit occurs too early, hampering an incipient recovery. However, as suggested by historical experience, the main risk is arguably exiting too late and slowly (Borio (2008) and BIS (2009b)). After extended periods of support, central banks can be especially cautious, given the perceived risk of generating unwelcome and damaging market reactions. And political economy pressures are overwhelmingly in the direction of delaying exit. At the macro level, the concern is that such a delayed exit may risk accommodating the build-up of a new set of financial imbalances or else lead to inflationary pressures. At the micro level, it may weaken unnecessarily the ability of markets to work effectively without official support and may distort the level playing field.
Which is something we’ve heard before in relation to Japan’s QE.
(H/T Alea for the BIS paper)

Related links:
The unthinkable - FT Alphaville
Monetary policy moves send mixed message - FT