Bank of Japan quantitative easing - lessons for the Fed

In the depth of the Japanese "lost decade", the Bank of Japan changed monetary policy to try the radical approach of quantitative easing. It actually was the only alternative to a liquidity trap from a deflationary environment where rates were at zero. The Bank of Japan had moved to zero interest rates in March 1999, but the policy of just keeping rates at zero was not enough.

The BOJ Quantitative easing set current account balances, the equivalent of excess reserves, to a quantitative target which would be maintained until CPI was greater than zero on a year over year basis. The policy started on March 2001 and lasted until March 2006. The current account balance initially moved from 1 trillion yen to 5 trillion yen, but the target was increased nine times from from March 2001 to December 2004 for a target pf 35 trillion yen.

The Fed seems to be on similar path so it seems important to discuss whether the BOJ quantitative easing was a success. The answer is that its success was only marginal. First, the size of the increases was much larger than anticipated and the impact of trying to stop deflation took longer than expected. Investors in the US should recognize that there will not be an quick fixes even if we have started quantitative easing much sooner than the Japanese.

Studies of the Japanese financial markets show that the the BOJ easing was able to effect longer rates and bring them down slightly. However, empirical studies suggests that a 10 trillion yen expansion was able to only bring down three and five years interest rates by less than 20 bps. There will not be a significant reduction in US rates if we use the Japanese case as a benchmark.

The BOJ found that there was no overall stimulation of lending from their quanttitive easing. Research did find that the easing policy reduced the standard deviation of CD rates across Japanese financial institutions. That is, the lower quality financial institution were able to reap a benefit from the increased reserves. However, some have concluded that the lowering of risk for those firms of lower quality actually delayed structural reforms. Poor institutions lasted longer than they would have until normal policies.

The Fed is moving to quantitative easing but it is not clear that this will be a panacea for all what ails the US economy. Now there may be limited choices and quantitative easing may be the only alternative, but this alternative does not mean that we will have a quick cure to our problems.