Don't Just Hold It, Keep Buying Is the Recipe for Successful QE

(Bloomberg) -- Central bankers across the globe have lauded quantitative easing, the crisis tool that they say averted outright deflation. Now a Bank of England staff blog suggests policy makers should resist the temptation to keep the bloated balance sheets they’ve acquired.

Economist Richard Harrison’s study finds that QE’s stimulus comes from buying assets, rather than from owning them. In a post on the BOE’s Bank Underground blog on Monday, he says that’s due to an “expectations channel,” whereby bond investors recognize the central bank will start purchases when it runs out of room to cut rates and react accordingly, pushing down yields.

That means simply holding large quantities of bonds on the balance sheet won’t have the same kind of effect.

“‘Active’ QE improves welfare precisely because it is active,” writes Harrison, who works in the BOE’s Monetary Assessment and Strategy Division. “If the central bank merely holds a fixed proportion of long-term debt on its balance sheet, then it will not replicate this feature of an active QE policy.”

Harrison’s findings go to the heart of the debate that the European Central Bank is having on whether to stop adding to bond purchases after September next year as its economy enjoys the best growth in a decade. While some policy makers argue that the stock of holdings on the books is the primary source of stimulus, others say the monthly flow must be kept going until euro-area inflation is clearly entrenched.

While Harrison sidesteps his European colleagues’ conundrum, his model does not support the idea of permanently large central bank balance sheets -- something equally relevant to the BOE, which has said it plans to maintain its holdings until interest rates reach a level where they could be cut “materially” in case of a negative shock to the economy.

Harrison also suggests QE could become a more familiar tool in the future.

“If real interest rates remain low for a prolonged period, perhaps because of secular factors, then we would expect the lower bound on policy rates to be encountered more often. During these more frequent lower bound episodes, the model predicts that QE should be used to help support spending and inflation.”

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