## wpiea2024103-print-pdf - Introduction ## Source details **Canonical URL:** [wpiea2024103-print-pdf - Introduction](https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024103-print-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2024/english/wpiea2024103-print-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2024/english/wpiea2024103-print-pdf.pdf.json) --- ### Background and rationale for QE - Central banks added unconventional tools—quantitative easing (QE) and forward guidance—after the Global Financial Crisis (GFC) to operate with limited policy space and asymmetric downside risks. - Policy strategies adjusted for the effective lower bound (ELB); example: an asymmetric form of average inflation targeting in the United States that promised to make up for persistent inflation undershoots but not overshoots. - The view that the Phillips Curve was flat reduced perceived need to account for upside inflation risks when deploying QE and forward guidance. ### Pandemic lessons and risks from QE - Rapid post‑COVID‑19 inflation suggests potential significant nonlinearities in the Phillips Curve and the need to pay greater attention to upside inflation risks. - QE likely supported recovery from the COVID‑19 pandemic but may have been continued too long and contributed to overheating and the post‑COVID‑19 inflation boom. - Forward guidance associated with QE may have inhibited timely liftoff of policy rates. - QE increased central bank balance sheet maturity/duration risk, producing large realized losses in a rising interest rate environment; public backlash against such losses can be difficult to manage and could, in some cases, undermine central bank credibility and independence. ### Societal evaluation framework - Appropriate evaluation of QE should adopt a broad societal perspective, assessing macroeconomic benefits against consolidated fiscal costs and other welfare‑relevant factors (e.g., distributional effects). - Consolidated fiscal costs include central bank losses but must also account for initial central bank profits from QE and effects on government tax revenue, expenditure, and debt‑servicing costs. - Focusing narrowly on central bank balance sheet losses is misleading when assessing QE from a societal standpoint. ### Core questions addressed - Under what circumstances is QE appropriate (deep vs. shallow liquidity traps)? - How might QE modalities be adjusted to minimize risks (e.g., escape clauses)? - Should central bank capital and profit distribution policies be modified given larger and riskier balance sheets? ### Methodological approach - Use of an open economy DSGE model building on Kolasa and Wesolowski (2020) with: - Bond market segmentation allowing QE to affect term premia. - Behavioral discounting as in Gabaix (2020) to mitigate the forward guidance puzzle. - A nonlinear Phillips Curve as in Harding, Linde, and Trabandt (2022, 2023). - Model is calibrated conservatively on QE effectiveness (benchmarking to academic meta‑analysis excluding central bank estimates). ### High‑level conclusions (preview) - QE has substantial macroeconomic benefits in a deep recession and liquidity trap even under conservative calibration of asset purchase effects on term premiums. - Consolidated fiscal position typically improves materially in deep traps because faster recovery boosts the primary balance, debt service costs fall, and higher price levels lower the real value of existing debt. - Central bank profits typically remain positive in deep traps provided the yield curve is upward sloping, although profits can turn significantly negative if policy must be tightened rapidly. - QE is considerably less attractive in shallow liquidity traps (interest pinned at zero mainly because inflation and expectations are well below target while output is near potential): modest QE can be beneficial under modal outlooks, but modest upside shocks (e.g., fiscal expansion) can make QE counterproductive by overheating the economy and raising inflationary pressures. - Forward guidance commitment elements of QE can amplify overheating and reduce central bank nimbleness in responding to upside surprises. ### Model simulation design and implementation - Model features: portfolio transaction costs and segmentation (Chen et al., 2012; Kolasa and Wesolowski, 2020), behavioral discounting, nonlinear Phillips Curve; parameterized conservatively. - QE implementation in simulations: - Stock of assets peaks at 10 percent of baseline GDP after a year. - Sequence of purchases reduces the term premium initially by about 50 basis points. - ELB constraint assumed to be 0 on the short‑term policy rate. ### Key numerical simulation results - Deep liquidity trap (analogous to post‑GFC): - QE boosts output about .8 percent relative to baseline after six quarters and inflation 0.2 percentage points. - Central bank capital rises about 0.5 percent after five years. - Consolidated fiscal position improves by about 5 percent of baseline GDP after five years (panel e difference). - Even with a faster recovery and inflation surge (ex post scenario), QE still provides substantial macro benefits; central bank profits may fall sharply with rapid policy tightening, but consolidated fiscal position still tends to improve. - Shallow liquidity trap (output a little less than 1 percent below potential; inflation about 0.8 percentage points below target): - A modest QE program can be beneficial under the modal outlook but has less “bang for the buck” (output rise about two‑thirds as large as in the deep trap scenario). - Upside shocks after QE initiation can make QE counterproductive, causing overheating. - Commitment aspects (forward guidance delaying rate hikes until after QE ends) can exacerbate overheating and reduce central bank responses’ nimbleness. - QE in shallow traps is more likely to produce central bank losses because policy rates may later need to rise well above neutral; consolidated fiscal outcomes may improve in baseline simulation but could deteriorate if the central bank must shift its reaction function aggressively. - Calibration note: - QE effects on output are calibrated to be somewhat smaller than effects reported in academic meta‑analyses (Fabo et al., 2021) to take a conservative view. ### Modalities, communication, and escape clauses - QE effectiveness depends on communication that: - (i) markets expect QE to remain in effect for a prolonged period (pushing down term premiums), - (ii) policy rate adjustment will not begin until well after QE ends, and - (iii) rate adjustment is likely to be gradual. - Given more pronounced upside inflation risks, central bank communication should be clearer about the possibility of exiting QE early and raising policy rates faster. - In shallow liquidity traps, use of “escape clauses” to signal conditions that could terminate QE early and call for faster policy adjustment (possibly before net purchases cease) is particularly warranted. - Escape clauses reduce the risk of being “trapped” by forward guidance but may shorten market expectations about how long rates stay at the ELB, making QE less potent in shallow traps. - Alternatives and complements to QE: - Negative policy rates: examples include the ECB at minus 50 basis points and the Swiss National Bank at minus 75 basis points; evidence shows substantial passthrough to lending and deposit rates in these experiences. - Greater reliance on forward guidance without tying it to QE. - Fiscal policy as a complementary tool when monetary policy is constrained. ### Central bank capital policies and risk‑based provisioning - QE and floor operating systems have increased central bank balance sheet size and exposure to interest‑rate, credit, and FX risks. - Practical concern: weak financial position or suspension of distributions can threaten operational independence and invite political incursions. - Existing capital policies vary widely: - Some central banks legally required to maintain minimum capital specified as a fixed nominal amount or as a percentage of monetary liabilities. - Profit distribution rules vary: profits rebuild capital if below minimum; otherwise distributed to government; some laws set fixed percentages to reserves and government; in other cases bilateral negotiation determines allocation. - Many capital distribution policies are not risk‑based; shortfalls usually addressed by organic rebuilding or discretionary government recapitalizations. - Recent risk‑based provisioning examples: Bundesbank suspending remittances in 2020; Netherlands Central Bank in 2021. - Key facets of a risk‑based (dynamic) capital policy: - Quantify key risks (interest rate risk, maturity mismatch, credit risk, foreign exchange risk). - Use scenario analysis / stress tests (central bank stress‑testing, CBST model) to project profits and capital paths across macro scenarios and gauge adequate capital levels or comfort ranges. - Allow temporary suspension of profit distributions to build buffers (“provisioning”) against plausible shocks—even if current profits are positive and capital above statutory minima. - Board oversight, a central bank “risk unit,” and transparency with government are important institutional elements. - Tradeoffs and implementation challenges: - Breadth of provisioning: provision against a wide range of potential crisis actions versus focus on core risks associated with operating a floor system and managing FX reserves. - Whether to provision based on modal outlook or tail risks (tail provisioning requires much larger buffers). - Potential government resistance to large retained “war chests” and concerns about agency problems (weakened governance, mission creep, excessive staffing). - Necessity of coordination with Treasury and potential legislative changes; transparency and accountability are essential. ### Scenario analysis, provisioning, and government backstops - Central banks could use windfall gains (for example when yields fall and profits rise) to build capital cushions against possible future losses when interest rates rise. - Many central banks currently “smooth through” profit volatility by basing distributions on average profits over a multi‑year backward window; a forward-looking approach would instead base distributions on an evaluation of future risks. - Central banks may consider provisioning for risks associated with prospective large-scale use of balance sheet policies in the future, including liquidity support and QE. - Political economy difficulties make ex ante provisioning for a range of contingencies challenging; scenario analysis can help build political support for equity backstops from the Treasury when needed. - Ex post Treasury backstops: - Are desirable to protect the central bank’s balance sheet and to signal political support for central bank actions. - Require the government to decide ex post which central bank actions to backstop and the magnitude of support it is willing to provide. - Could rely on a stress testing exercise like the one proposed for the central bank. ### Crisis response and profit retention heuristics - In a crisis, forward‑looking profit retention can buttress the central bank’s capital position. - Scenario analysis can consider capital evolution while accounting for government backstops (often partial). - Central bank profits—especially early in programs such as QE—are often sizeable because policy rates are very low; retaining a large share of profits to offset future sharp declines would help buttress capital through the recovery period. ### Key policy implications and concluding points - QE in deep recession: - QE policies are likely to have substantial benefits in a deep recession in which policy rates are expected to be constrained by the ELB for a protracted period. - QE boosts output and inflation and improves the consolidated fiscal position of the government. - QE is likely to be a very useful tool in the event that the ELB again becomes severely binding. - Caution in shallow liquidity traps: - Given recent high inflation experience, more caution is warranted in using QE in a shallow liquidity trap where the central bank mainly faces a low inflation problem. - QE may appear beneficial ex ante but can cause overheating ex post given nonlinearities in the Phillips Curve, potential for outsized easing of financial conditions, and the possibility of other inflation‑raising shocks after deployment of QE. - Negative interest rates may be preferable in these circumstances. - Duration risk and exposures: - Duration risk from QE compresses term premia and eases financial conditions but increases exposure to losses if interest rates rise enough. - Benefits of QE can be positive even when the central bank experiences losses, but losses can be a headwind for credibility and may weaken independence. - Reassessing capital and distribution policies: - Central banks should consider reassessing capital policies—including profit distribution rules—to account for much riskier balance sheets. - Some central banks may retain simple distribution policies; others may benefit from a more forward‑looking approach to assessing balance sheet risks and allocating profits between building capital and distributions to the government. - Greater flexibility to retain profits and build buffers can help protect financial autonomy and support independence and appears high on the agenda for central bank reforms. ### Exact numeric references preserved from the text - QE peak stock: 10 percent of baseline GDP. - Initial reduction in term premium: about 50 basis points. - ELB constraint assumed: 0 on the short‑term policy rate. - Deep trap: output boost ~ .8 percent after six quarters; inflation boost 0.2 percentage points. - Deep trap consolidated fiscal improvement: about 5 percent of baseline GDP after five years. - Central bank capital rise in deep trap: about 0.5 percent after five years. - Shallow trap baseline gap: output a little less than one percent negative; inflation about 0.8 percentage points below target. - Shallow trap output response about two‑thirds the size of deep trap response. - Policy example figures: "3.5 percent", "3 percent (say the “steady state level”)", "2 percent". *Source: wpiea2024103-print-pdf - Introduction (IMF Working Paper content provided).* ### Introduction ........................................................................................................... ### wpiea2024103-print-pdf - Introduction ### Major sections (with page references) - Introduction ......................................................................................................................................................... 3 - Quantitative Easing Before the Pandemic ........................................................................................................ 6 - Implications of the Inflation Surge for the Use of QE ...................................................................................... 8 - Illustrative Model Simulations....................................................................................................10 - The Modalities of QE and Some Alternatives ................................................................................................. 16 - How Should Central Bank Capital Policies be Modified to Account for Bigger and Riskier CB Balance Sheets? .............................................................................................................................................................. 17 - Current Capital Policies ................................................................................................................................ 18 - Key Facets of a Risk-Based Approach ......................................................................................................... 19 - What is the Right Breadth of Risk-Based Provisioning? .............................................................................. 20 - Whether to Move Toward More Risk-Based Capital Policies? ..................................................................... 21 - Conclusion ......................................................................................................................................................... 23 - References ......................................................................................................................................................... 24 ### Figures listed - 1. Ex ante: Deep Liquidity Trap ........................................................................................................................ 12 - 2. Ex post: Deep Liquidity Trap ....................................................................................................................... 13 - 3. Ex ante: Shallow Liquidity Trap ................................................................................................................... 14 - 4. Ex Post: Shallow Liquidity Trap with Forward Guidance Commitment ................................................... 15 - 5. Distribution of Central Bank Profits to the Government ........................................................................... 19 ### Document series and identifier - IMF WORKING PAPERS New Perspectives on Quantitative Easing and Central Bank Capital Policies - INTERNATIONAL MONETARY FUND *Source: wpiea2024103-print-pdf - Introduction (canonical PDF: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024103-print-pdf.pdf)* ### Introduction ### Introduction ### Background: pre‑pandemic playbook and rationale for QE - Central banks incorporated unconventional monetary tools—quantitative easing (QE) and forward guidance—into the policy arsenal after the Global Financial Crisis (GFC) to operate with limited policy space and asymmetric downside risks. - Policy strategies were adjusted to address the effective lower bound (ELB); examples include an asymmetric form of average inflation targeting in the United States that promised to make up for persistent inflation undershoots but not overshoots. - The view that the Phillips Curve was flat reduced perceived need to account for upside inflation risks when deploying QE and forward guidance. ### Pandemic experience and lessons for QE use - The rapid surge in inflation after the COVID‑19 pandemic suggests potential significant nonlinearities in the Phillips Curve and the need to pay greater attention to upside inflation risks. - QE likely supported recovery from the COVID‑19 pandemic but may have been continued too long and contributed to overheating and the post‑COVID‑19 inflation boom. - Forward guidance associated with QE may have inhibited timely liftoff of policy rates. - QE exposed central bank balance sheets to greater maturity/duration risk, producing large realized losses in a rising interest rate environment; public backlash against such losses can be difficult to manage and could, in some cases, undermine central bank credibility and independence. ### Framework for evaluating QE: societal perspective - The paper argues the appropriate evaluation of QE should adopt a broad societal perspective, assessing macroeconomic benefits against consolidated fiscal costs and other welfare-relevant factors (e.g., distributional effects). - Consolidated fiscal costs include central bank losses but must also account for initial central bank profits from QE and effects on government tax revenue, expenditure, and debt‑servicing costs. - Focusing narrowly on central bank balance sheet losses is misleading when assessing QE from a societal standpoint. ### Questions addressed - Under what circumstances is QE appropriate (deep vs. shallow liquidity traps)? - How might QE modalities be adjusted to minimize risks (e.g., escape clauses)? - Should central bank capital and profit distribution policies be modified given larger and riskier balance sheets? ### Methodological approach - Use of an open economy DSGE model building on Kolasa and Wesolowski (2020) with: - Bond market segmentation allowing QE to affect term premia. - Behavioral discounting as in Gabaix (2020) to mitigate the forward guidance puzzle. - A nonlinear Phillips Curve as in Harding, Linde, and Trabandt (2022, 2023). - Model is calibrated conservatively on QE effectiveness (benchmarking to academic meta‑analysis excluding central bank estimates). ### High‑level conclusions preview - QE has substantial macroeconomic benefits in a deep recession and liquidity trap even under conservative calibration of asset purchase effects on term premiums. - Consolidated fiscal position typically improves materially in deep traps because faster recovery boosts the primary balance, debt service costs fall, and higher price levels lower the real value of existing debt. - Central bank profits typically remain positive in deep traps provided the yield curve is upward sloping, although profits can turn significantly negative if policy must be tightened rapidly. - QE is considerably less attractive in shallow liquidity traps (interest pinned at zero mainly because inflation and expectations are well below target while output is near potential): modest QE can be beneficial under modal outlooks, but modest upside shocks (e.g., fiscal expansion) can make QE counterproductive by overheating the economy and raising inflationary pressures. - Forward guidance commitment elements of QE can amplify overheating and reduce central bank nimbleness in responding to upside surprises. ### Policy implication: tradeoffs and alternatives - QE is welfare‑improving in deep liquidity traps but requires greater caution closer to full employment; alternatives such as pushing interest rates negative before turning to QE deserve consideration. - While central bank losses should not be the sole criterion for QE desirability, large losses may weaken financial autonomy and independence—motivating reconsideration of central bank capital and profit distribution policies. --- ### Quantitative model simulations: scenarios and key results - Model features: portfolio transaction costs and segmentation (Chen et al., 2012; Kolasa and Wesolowski, 2020), behavioral discounting, nonlinear Phillips Curve; parameterized conservatively. - QE implementation in simulations: - Stock of assets peaks at 10 percent of baseline GDP after a year. - Sequence of purchases reduces the term premium initially by about 50 basis points. - ELB constraint assumed to be 0 on the short‑term policy rate. - Deep liquidity trap (analogous to post‑GFC): - QE boosts output about .8 percent relative to baseline after six quarters and inflation 0.2 percentage points. - Central bank capital rises about 0.5 percent after five years. - Consolidated fiscal position improves by about 5 percent of baseline GDP after five years (panel e difference). - Even if a faster recovery and inflation surge occur (ex post scenario), QE still provides substantial macro benefits; central bank profits may fall sharply with rapid policy tightening, but consolidated fiscal position still tends to improve. - Shallow liquidity trap (output a little less than 1 percent below potential; inflation about 0.8 percentage points below target): - A modest QE program can be beneficial under the modal outlook but has less “bang for the buck” (output rise about two‑thirds as large as in the deep trap scenario). - Upside shocks arriving after QE initiation can make QE counterproductive, causing overheating. - Commitment aspects (forward guidance delaying rate hikes until after QE ends) can exacerbate overheating and make central bank responses less nimble. - QE in shallow traps is more likely to produce central bank losses because policy rates may later need to rise well above neutral; consolidated fiscal outcomes may still improve in baseline simulation but could deteriorate if the central bank must shift its reaction function aggressively. - Calibration note: - QE effects on output are calibrated to be somewhat smaller than effects reported in academic meta‑analyses (Fabo et al., 2021) to take a conservative view. ### Illustrative numerical magnitudes preserved from simulations and calibration - QE peak stock: 10 percent of baseline GDP. - Initial reduction in term premium: about 50 basis points. - Deep trap: output boost ~ .8 percent after six quarters; inflation boost 0.2 percentage points. - Deep trap consolidated fiscal improvement: about 5 percent of baseline GDP after five years. - Central bank capital rise in deep trap: about 0.5 percent after five years. - Shallow trap baseline gap: output a little less than one percent negative; inflation about 0.8 percentage points below target. - Shallow trap output response about two‑thirds the size of deep trap response. --- ### Modalities of QE: communication, escape clauses, and alternatives - QE effectiveness depends on communication that: - (i) markets expect QE to remain in effect for a prolonged period (pushing down term premiums), - (ii) policy rate adjustment will not begin until well after QE ends, and - (iii) rate adjustment is likely to be gradual. - Given more pronounced upside inflation risks, central bank communication should be clearer about the possibility of exiting QE early and raising policy rates faster. - In shallow liquidity traps, there is a particularly strong case for using “escape clauses” to signal conditions that could terminate QE early and call for faster policy adjustment (possibly before net purchases cease). - Escape clauses reduce the risk of being “trapped” by forward guidance but may shorten market expectations about how long rates stay at the ELB, making QE less potent in shallow traps. - Alternatives and complements to QE: - Negative policy rates: some central banks set policy rates below zero (ECB at minus 50 basis points; Swiss National Bank at minus 75 basis points) for prolonged periods with evidence of substantial passthrough to lending and deposit rates; empirical evidence suggests effective transmission and limited financial stability consequences in these experiences. - Greater reliance on forward guidance without tying it to QE. - Consideration of fiscal policy as a complementary tool when monetary policy is constrained. --- ### Central bank capital policies: challenges and risk‑based alternatives - QE and floor operating systems have increased central bank balance sheet size and exposure to interest‑rate, credit, and FX risks. - While a fully independent central bank’s decisions ideally do not depend on capital, in practice a weak financial position or suspension of distributions can threaten operational independence and invite political incursions. - Existing capital policies vary widely: - Some central banks legally required to maintain minimum capital specified as a fixed nominal amount (example: 20 billion krona for the Riksbank) or as a percentage of monetary liabilities. - Profit distribution rules vary: profits used to rebuild capital if below minimum; otherwise distributed to government; some laws set fixed percentages to reserves and government; in other cases bilateral negotiation determines allocation. - Many capital distribution policies are not risk‑based; shortfalls are usually addressed by organic rebuilding or discretionary government recapitalizations. - Recent examples of risk‑based provisioning include the Bundesbank suspending remittances in 2020 and the Netherlands Central Bank in 2021 to build buffers. - Key facets of a risk‑based (dynamic) capital policy: - Quantify key risks (interest rate risk, maturity mismatch, credit risk, foreign exchange risk). - Use scenario analysis / stress tests (central bank stress‑testing, CBST model) to project profits and capital paths across macro scenarios and gauge adequate capital levels or comfort ranges. - Allow for temporary suspension of profit distributions to build buffers (“provisioning”) against plausible shocks—even if current profits are positive and capital above statutory minima. - Board oversight, a central bank “risk unit,” and transparency with government are important institutional elements. - Tradeoffs and implementation challenges: - Breadth of provisioning: provision against a wide range of potential crisis actions versus focus on core risks associated with operating a floor system and managing FX reserves. - Whether to provision based on modal outlook or tail risks (tail provisioning requires much larger buffers). - Potential government resistance to large retained “war chests” and concerns about agency problems (weakened governance, mission creep, excessive staffing). - Necessity of coordination with Treasury and potential legislative changes; transparency and accountability are essential. ### Practical considerations and policy heuristics - Stress testing can inform profit allocation decisions by quantifying how much of windfall profits to retain to offset future potential losses; for example, retaining some profits when policy rates decline to build buffers against future interest rate hikes that would induce losses. - The central bank stress‑testing approach builds on Hall and Reis (2015) and projects exposure to interest rate, credit, and exchange rate risk. - For central banks with high perceived risk that capital weakness could impair independence—and for those with limited seigniorage—moving toward risk‑based provisioning and seeking government backing for such frameworks may be desirable. - Even for central banks confident of operational independence regardless of capital position, enhanced transparency via stress testing and fiscal/macro assessment of balance sheet policies is valuable for public accountability. ### Concluding implications from the Introduction - QE remains a valuable tool in deep liquidity traps, with sizable macro and consolidated fiscal benefits even accounting for possible central bank losses. - Greater caution is warranted when considering QE in shallow liquidity traps due to higher overheating and balance sheet loss risk, amplified by commitment aspects of QE and nonlinear Phillips Curve dynamics. - Central banks should consider modifying capital distribution policies to be more forward‑looking and risk‑based, using stress testing to provision against plausible balance sheet shocks and preserve financial autonomy. - Choices about capital provisioning, escape clauses, and use of alternative tools (negative rates, fiscal support) involve tradeoffs that require clear legal frameworks, transparency, and coordination with governmental oversight bodies. *Source: wpiea2024103-print-pdf - Introduction (IMF Working Paper content provided).* ### 3.5 percent and it reduces its policy rate from 3 percent (say the “steady state level”) to 2 percent given a ### wpiea2024103-print-pdf - 3.5 percent and it reduces its policy rate from 3 percent (say the “steady state level”) to 2 percent given a ### Scenario analysis, provisioning, and government backstops - Central banks could use windfall gains (for example when yields fall and profits rise) to build capital cushions against possible future losses when interest rates rise. - Many central banks currently “smooth through” profit volatility by basing distributions on average profits over a multi-year backward window; a forward-looking approach would instead base distributions on an evaluation of future risks. - Central banks may consider provisioning for risks associated with prospective large-scale use of balance sheet policies in the future, including liquidity support and QE. - Political economy difficulties make ex ante provisioning for a range of contingencies challenging; central banks may therefore find it desirable to use scenario analysis to strengthen political support for providing equity backstops from the Treasury to address significant risks to macroeconomic and financial stability when they arise. - Ex post Treasury backstops: - Are desirable to protect the central bank’s balance sheet and to signal political support for central bank actions. - Require the government to decide ex post which central bank actions to backstop and the magnitude of support it is willing to provide. - Could rely on a stress testing exercise like the one proposed for the central bank. ### Crisis response and forward-looking profit retention - In the event of a crisis, a forward-looking policy can help buttress the central bank’s capital position. - Scenario analysis can be used to consider how the central bank’s capital position would evolve while taking account of government backstops (which are often only partial). - Central bank profits—especially in the early phases of programs such as QE—are often sizeable, reflecting that policy rates are very low; retaining a large share of profits to offset future sharp declines would help buttress the central bank’s capital position through the recovery period. ### Conclusion — four key points - QE in deep recession: - QE policies are likely to have substantial benefits in a deep recession in which policy rates are expected to be constrained by the ELB for a protracted period. - QE boosts output and inflation and improves the consolidated fiscal position of the government. - QE is likely to be a very useful tool in the event that the ELB again becomes severely binding. - Caution in shallow liquidity traps: - In light of the recent experience of high inflation, more caution is warranted in using QE in a shallow liquidity trap where the central bank mainly faces a low inflation problem. - QE may appear beneficial ex ante but can cause overheating ex post given important nonlinearities in the Phillips Curve, the potential for an outsized easing of financial conditions, and the possibility of other inflation-raising shocks after deployment of QE. - Negative interest rates may be preferable in these circumstances. - Duration risk and exposures: - The duration risk central banks take on with QE fuels risk-taking, compresses term premia, and eases financial conditions broadly. - A side effect is increased exposure to losses if interest rates rise enough. - The benefits of QE are often significantly positive even when the central bank experiences losses (for example if the recovery is unexpectedly fast and the yield curve inverts), but losses can be a headwind for central bank credibility and may weaken independence in some cases. - Reassessing capital and distribution policies: - Central banks should consider reassessing their capital policies—including for distributing profits to the government—in light of much riskier balance sheets. - Many central banks retain simple distribution policies developed in an environment of small balance sheets and little duration (or credit) risk. - Central banks that view capital positions and profit distributions as having little bearing on mandate fulfillment may retain these strategies. - Other central banks may benefit from a more forward-looking approach to assessing balance sheet risks and allocating profits between building capital and distributions to the government. - Allowing central banks greater flexibility in this regard can help protect financial autonomy and support independence and appears high on the agenda for central bank reforms. ### Key statistics and exact numeric references from the text - Example scenario figures mentioned: "3.5 percent", "3 percent (say the “steady state level”)", "2 percent". - Policy context identifiers: "ELB", "QE". - Working Paper identifier: "Working Paper No. WP/2024/103". *IMF WORKING PAPERS New Perspectives on Quantitative Easing and Central Bank Capital Policies — INTERNATIONAL MONETARY FUND* --- _Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024103-print-pdf.pdf_