Quantitative Easing vs Negative Rates: New Evidence Questions Policy Effectiveness

Global negative-yield debt has reached a staggering $17.5 trillion. Quantitative easing programs have driven central bank reserves past $4 trillion. These numbers represent the highest levels of monetary intervention ever recorded. The Federal Reserve launched a $700 billion emergency asset purchase program as the COVID-19 pandemic intensified these figures.

Traditional interest rate policies sometimes fall short, and central banks worldwide now rely on these unconventional monetary tools. The European Central Bank set negative rates at -0.5% in 2019. The Federal Reserve’s quantitative easing made up 56% of Treasury issuance through early 2021.

This complete analysis gets into how well quantitative easing and negative interest rates work to stimulate economic growth, inflation, and financial stability. Major economies provide valuable lessons through their ground application of these policies. Japan’s trailblazing QE program from 2001 and Europe’s largest longitudinal study of negative rates help us learn about which policy tool produces better outcomes.

 

The Mechanics of Quantitative Easing and How It Works

Quantitative easing works through a simple yet powerful process. Central banks create new money electronically to buy financial assets from commercial banks and other financial institutions. This process pumps liquidity into the financial system and expands the monetary base beyond what traditional interest rate adjustments can achieve.

Central bank asset purchases and balance sheet expansion

Central banks buy government bonds and sometimes private sector securities like mortgage-backed securities (MBS). These purchases happen in secondary markets instead of directly from governments. The process swaps the financial institutions’ investment holdings for cash.

The central bank funds these purchases by creating new bank reserves. People often call this “printing money” though it happens digitally. The assets and liabilities on the central bank’s balance sheet grow together, which leads to major expansion.

The Eurosystem’s bond holdings under the Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP) reached their highest point at more than €5 trillion. This amount equals about 35% of euro area nominal GDP. The United Kingdom and United States saw similar levels.

Transmission channels to the real economy

QE disrupts the economy through several distinct channels. The portfolio rebalancing channel kicks in as investors who sell assets to the central bank spend their money on other securities. This reduces yields in assets of all types. To name just one example, research shows funds moved more than 60% of their money into corporate bonds after selling Treasuries to the Fed.

The signaling channel works through QE announcements that lower expectations about future policy rates. This shows the central bank’s commitment to accommodative monetary policy. The liquidity channel also reduces premiums on purchased assets. This works especially well during financial stress when assets become illiquid.

Other key transmission paths include:

• The market functioning channel helps dealers arbitrate markets during crises
• The uncertainty channel reduces financial market volatility
• The bank lending channel can boost credit supply by increasing banks’ reserve holdings

Research shows different channels work together but their strength changes over time. Studies also prove that QE announcements lower interest rates by reducing term premiums and changing expectations about future policy rates.

Federal Reserve’s implementation of QE (2008-2022)

The Federal Reserve ran four major QE programs since 2008. Each program tackled specific economic challenges. QE1 started in November 2008 during the global financial crisis. The Fed bought $200 billion in agency debt, $1.25 trillion in mortgage-backed securities, and $300 billion in long-term Treasury debt between March 2009 and March 2010.

QE2 launched in November 2010 after the Fed’s policy rate hit its lower bound. This program focused only on buying $600 billion of long-term Treasury securities at $75 billion monthly through Q2 2011. QE3 began in September 2012 with monthly purchases of $40 billion in mortgage-backed securities and $45 billion in Treasury securities. This program stood out because it didn’t specify a total purchase amount or timeline.

The Fed started QE4 in March 2020 to combat the COVID-19 pandemic. They bought $80 billion of agency debt and $40 billion of mortgage-backed securities monthly. This pushed the Fed’s balance sheet from $4 trillion before the pandemic to almost $9 trillion by early 2022.

These programs changed the market dramatically. To name just one example, the 10-year Treasury yield fell 107 basis points in just two days after QE1’s announcement. Research shows that every $100 billion in Treasury purchases by the Fed brought corporate bond yields down by about 8 basis points.

Negative Interest Rate Policy: Breaking the Zero Lower Bound

Several central banks undertook a bold experiment by implementing negative interest rates, going beyond the traditional zero barrier in monetary policy. This new approach challenges the basic idea that nominal interest rates can’t fall below zero. It creates new ways to stimulate the economy when regular tools hit their limits.

How negative rates function in banking systems

Negative interest rate policy (NIRP) works through a unique system: central banks charge financial institutions for depositing excess reserves instead of paying them interest. Banks must pay to keep their funds with central banks, which pushes them to lend money rather than hold onto cash. The policy affects interbank lending rates and wholesale funding costs by a lot, though its impact on retail customers varies.

NIRP creates a basic problem: banks face negative rates on their central bank deposits but don’t usually charge negative rates on retail deposits. This happens because people can take out physical cash that yields 0%. Economists call this the “effective lower bound” – a point just below zero based on the costs of storing actual currency.

Banks deal with this challenge in different ways. Banks with high deposits usually cover the costs themselves. They protect small depositors and apply negative rates mainly to big corporate clients. These institutions often make up for lower interest income by raising fees or changing their lending approach.

Banks in good financial health know how to pass negative rates to corporate deposits without losing many deposits. Research shows that deposits actually increased in sound banks even when they charged negative rates during NIRP periods.

Implementation across Europe and Japan (2014-2022)

The European Central Bank led the way among major central banks with negative rates in June 2014. They set their deposit facility rate at -0.10%. The ECB lowered this rate to -0.50% by September 2019 through several cuts and kept it there until 2022. Switzerland, Sweden, Denmark, and Japan also adopted NIRP to tackle specific economic issues.

Japan’s case offers valuable lessons after they introduced negative rates in 2016 at -0.1%. They used a three-tier system for bank reserves to reduce the impact on bank profits. The Bank of Japan ended this policy in March 2024 after eight years, raising rates to a range of 0.0%-0.1%.

Switzerland took rates lowest into negative territory. Their reference rate for one-month LIBOR reached -0.75% without obvious financial stability problems. The Eurosystem kept negative rates for almost eight years. Markets expected rates to stay negative for at least five more years as of 2021.

Theoretical benefits for economic stimulus

The main benefits of negative interest rates include:

• Stimulating lending and investment – NIRP makes holding reserves expensive for banks, which encourages them to turn excess liquidity into loans, especially among financially sound banks
• Encouraging consumer spending – People spend more and save less with negative rates, which boosts total demand
• Supporting portfolio rebalancing – Investors move from low-yielding deposits to riskier assets, which can boost economic activity through more investment
• Enhancing monetary policy transmission – NIRP can make other unusual policies work better, especially when central banks buy assets, by pushing banks to turn excess liquidity into loans

Economic models suggest negative rates could have cut economic slack in half during the 2008 recession if implemented then. Research also shows a “corporate channel” where companies with cash balances at negative rates reduce liquid assets and invest more in fixed assets.

Notwithstanding that, NIRP has its limits. It might hurt bank profits if rates go too negative. There’s a “reversal rate” where the negative effects on bank profits could reduce lending and economic activity.

Empirical Evidence: Effectiveness of Quantitative Easing

Two decades of data on quantitative easing shows mixed results about how well it works in different economies. Major central banks widely adopted this approach, but research shows varying levels of success in reaching their economic goals.

Impact on financial markets vs. real economic growth

Studies show QE worked well to lower government bond yields. The first round of QE brought yields down by up to 100 basis points in the US and 50 basis points in the UK. Later rounds of QE had less effect on yields.

The research points to a gap between improvements in financial markets and benefits to the real economy. QE boosted financial markets and asset prices well, but its effect on real economic growth was nowhere near as strong. Studies suggest that QE helped stabilize markets during crises but didn’t do much to create lasting economic growth.

The Federal Reserve’s balance sheet grew from $4.2 trillion in late 2019 to $8.8 trillion by late 2021, reaching 36% of GDP. This massive intervention’s impact on real economic growth remains unclear.

Asset price inflation and wealth inequality concerns

QE pushed asset prices higher, which helped equity and bond markets most. Research shows that wealthy households got the biggest gains from QE through rising stock and bond values. Financial wealth inequality kept growing before and during QE.

The Bank of England recognized that older people, who usually own more financial assets, benefited most from QE’s wealth effects. The Bank also said younger working people gained through better employment and income. Some studies suggest QE reduced overall wealth inequality by cutting unemployment rates, which helps lower-income households most.

New research shows QE widened the gap between the top 10% and others by boosting profits and equity prices. Yet it reduced inequality within the bottom 90% through lower unemployment.

Japan’s two-decade experiment with QE: Lessons learned

Japan’s early adoption of QE gives us a great way to learn about its long-term effects. The Bank of Japan started QE in 2001 and changed its target from short-term interest rates to current account balances. Japan has become a model for other central banks during this unprecedented monetary experiment.

Japan’s economy showed little response despite 20 years of aggressive monetary policy. The country now has the world’s highest debt at 264% of GDP as of 2022. Even with multiple QE rounds, including quantitative and qualitative monetary easing (QQE) in 2013 and negative rates in 2016, Japan still faces stagnant growth.

This long experience tells us that QE can help during crises but doesn’t deal very well with deep-rooted economic problems over time. Japan’s case shows that using QE for a long time hasn’t created lasting economic growth and has added to mounting fiscal deficits.

Recent Research on Negative Rates: Diminishing Returns

Recent studies that examine negative interest rate policies show clear signs of diminishing returns in financial systems. Central banks that pushed rates below zero discovered critical limitations. These limitations reduced policy effectiveness compared to traditional monetary tools.

Bank profitability and lending capacity constraints

Negative rates put unique pressure on bank profits through net interest margin compression. Banks usually avoid charging negative rates on retail deposits when policy rates drop below zero. This creates an imbalance that cuts into profits. Depositors can always take out physical cash that yields 0%, which sets a zero lower bound on deposit rates.

Small banks face bigger risks from negative rates than larger ones. These banks rely more on household deposit funding and can’t adjust lending margins like large banks. This makes it hard to offset pressure on their net interest margins. They try to make up for it by reducing operating costs or making more from fees. Danish small banks boosted their fee and commission income from 1% to 2% of assets on average.

Banks stop accepting deposits and reduce lending once the policy rate drops below certain levels. The situation gets worse over time – bank profits keep falling when interest rates stay low for long periods.

Consumer and business behavioral responses

People react differently to negative rates compared to normal interest rate cuts. Survey results show interesting patterns:

• Only 23% of people would do nothing if rates went negative
• Eight out of ten would move some money out of savings accounts
• More than a third would take their money out and keep cash

Different groups react in their own ways. Rich, older, and well-educated people tend to spend more under negative rates than other groups. These high-saving groups might help offset reduced spending elsewhere, which could boost the economy.

Businesses show their own unique response to negative rates. Companies with lots of cash start spending more on fixed investments instead of keeping money in banks. This might help counter some negative effects on bank lending.

Currency valuation effects and international capital flows

Negative rates change currency markets and international money flows. Research shows that NIRP announcements only briefly affect currency values. The markets react negatively in both currency and stock prices across countries on implementation days.

Low or negative rates make investments less attractive to foreign investors. This leads to lower demand for local currency, which drops exchange rates. Lower exchange rates might boost exports by making local goods cheaper in foreign markets.

Money flows get more complicated with negative rates. Safe currencies like the Swiss franc, Japanese yen, and US dollar still attract money during tough times, even with negative rates. The Danish krone shows similar patterns when you factor in foreign exchange activity.

Research suggests that “monetary policy that involves lowering interest rates below zero is neither stimulative nor efficiency-enhancing”. Current evidence points to diminishing—or even harmful—effects as rates go further below zero.

Comparative Analysis: Which Policy Tool Shows Better Results?

QE and negative interest rates show remarkable differences in their effectiveness as monetary policy tools. Major economies that implemented these unconventional approaches got results that challenged their original theoretical expectations.

Economic growth metrics under both regimes

QE shows more reliable positive effects on economic growth compared to negative interest rates. The 2008 financial crisis recovery got a boost from QE, though studies show its benefits mostly stayed within financial markets instead of spreading to broader economic activity. The negative rate policies in Europe and Japan barely helped growth despite years of trying.

Both tools wanted to increase lending, but banks responded differently. Banks dealing with negative rates held back on lending because they worried about profits. QE at least managed to increase credit availability temporarily through its effects on asset prices.

Inflation targeting success rates

Neither policy tool lived up to expectations for inflation targeting. Japan tried QE for two decades but failed to create lasting inflation. Their consumer price index stayed near zero from mid-2015 to March 2017 despite massive QE programs. The eurozone’s negative rates didn’t do much better at boosting inflation expectations.

Recent research points out that QE creates stronger inflation effects than regular monetary policy across many countries, regardless of how QE gets measured. This challenges the idea that negative rates work better for targeting inflation.

Long-term economic distortions and collateral damage

These policies create big economic distortions over time. QE leads to asset bubbles, especially in stocks and real estate. Evidence shows money flows almost entirely to real estate asset managers instead of productive sectors. Negative rates mess up investment decisions by encouraging small overinvestment while making it harder to fund bigger projects.

Negative rates hurt bank profits by squeezing net interest margins, which hits smaller banks hardest. QE risks pushing asset prices too high above their real values, which could cause problems when policies get reversed.

Does quantitative easing cause more inflation than negative rates?

Research suggests QE packs more punch for creating inflation than negative rates do. Studies across multiple countries back this up with strong evidence.

QE works through several channels at once – portfolio rebalancing, signaling, and liquidity. These combine to create more inflation pressure than negative rates alone. Looking at post-pandemic inflation trends, QE played a big role in recent inflation spikes because it directly expanded the money supply.

Conclusion

Research across different economies shows that QE delivers better results than negative interest rates, though neither tool fully achieved what it set out to do. QE helped stabilize financial markets during crisis periods, but its positive effects mostly showed up in asset prices rather than helping the broader economy grow.

Banks’ reactions reveal a key difference between these approaches. QE managed to keep credit flowing through its effects on asset prices, while negative rates made banks less willing to lend because they couldn’t make enough profit.

These tools created economic imbalances as time went on. QE led to asset bubbles and made wealth inequality worse, while negative rates hurt banks’ profits and pushed investors to make questionable decisions.

Studies show that QE ended up creating stronger inflation through several different channels, which became clear from inflation trends after the pandemic. This makes us ask whether central banks should keep using negative rates as their main monetary policy tool.

Central banks need to balance these trade-offs carefully when choosing unconventional monetary tools. The success of these tools depends heavily on specific situations, which suggests banks should focus more on matching solutions to particular economic conditions rather than applying them broadly.

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