The long farewell to quantitative easing

by Gavyn Davies

December 19, 2013 12:18 pm



The long farewell to quantitative easing, one of the most remarkable experiments in the history of macroeconomic policy, starts now. In the wake of the strong US employment data in recent months, the Federal Reserve finally announced that it will taper its asset purchases from January onwards.

The Fed’s balance sheet will stabilise in 2014, but will not begin to decline for several more years.

Variously described as the saviour of the global economy, totally irrelevant, a drug for the financial system or the harbinger of future inflation, QE is still controversial and insufficiently understood. Macro-economists are destined to be studying its effects for decades to come. Here are some early reflections.

When Lehman Brothers collapsed five years ago, the central banks immediately flooded the financial system with unprecedented amounts of liquidity, through open market purchases of debt, emergency repo facilities and direct lending through their discount windows. The term quantitative easing” was not commonly used at that stage, but the Fed’s Ben Bernanke, the Bank of England’s Mervyn King and others knew enough economic history to realise that they had to accommodate the sudden rise in liquidity preference in the banking system.

There was an awareness that the Fed’s failure to do this in 1931-33 had caused a massive deleveraging of the banking system as banks scrambled for cash, and that the resulting implosion in the money supply and bank credit had probably caused the Great Recession. The banking system as a whole could only increase its net holdings of liquid assets against an outside agency, the central bank, because otherwise a rise in one bank’s liquid assets would have been cancelled out by a rise in another bank’s liquid liabilities.

Fortunately, Mr Bernanke and others recognised that this required an increase in commercial banks’ liquid assets at the central bank, which involved a rise in the monetary base. Their willingness to permit this to occur prevented another Great Depression, a signal achievement for modern monetary policy.

The story continued in 2009 with a realisation that monetary conditions needed to be eased further, but by now short-term interest rates had reached the zero lower bound, or ZLB. Many economists thought that further expansion of the monetary base became irrelevant at that stage, since the Fed was simply swapping one form of short-dated government liability (money) for another (debt). But the Fed refused to accept this, and it pressed ahead with what it calledcredit easing”.

In 2009, in what is now termed QE1, attention turned to buying longer-dated assets, in an effort to reduce credit spreads and remove bad assets from the balance sheets of the banking sector. This also worked. Confidence in the banking system began to improve, mortgage interest rates fell and credit spreads narrowed. Many observers warned that the resulting further increase in the monetary base would have damaging effects, including moral hazard in the banking system, and rapidly rising inflation.

The latter, at least, did not happen. Broad money aggregates failed to rise in line with the monetary base, so money multipliers in the economy collapsed, as they had in Japan in similar circumstances in the previous decade. Inflation expectations did not rise in line with the monetary base either. The central banks became more emboldened by the early success of their interventions.

By 2010 another problem was looming. Government budget deficits had doubled or tripled as a result of the recession, and some deliberate fiscal easing. But the major economies were slowing again, and the central banks, refusing to accept the constraints of the ZLB, wanted further reductions in long-term interest rates. In November 2010 the Fed announced QE2, explaining that it expected this to work through portfolio balance effects. They would remove bond duration from the hands of the private sector, inducing investors to seek other forms of risk assets, thus reducing risk premia.

This step was bitterly criticised by economists from several different quarters. Some thought it would be irrelevant, because the Fed’s purchases would have no meaningful effect on bond yields in the massive Treasury marketplace. Others thought it would involve fiscal dominance over the central banks, which would end in an inflationary crisis of the type we are now witnessing in India. Still others warned that it would result in an unhealthy reach for yield which would create bubbles in parts of the financial system.

Initially, most of these warnings once again proved false. The central banks began to argue that they had discovered a new form of monetary easing, which could be calibrated by adjusting the size of their balance sheets. The extent of the easing, they said, should be measured by the absolute size of the outstanding stock of purchases, and not by their rate of change. Long-term bond purchases were increased further in Operation Twist in September 2011 and by QE3 in September last year. This final phase of quantitative easing was particularly audacious, since it involved an open-ended commitment by the Fed to buy long-term bonds until a substantial improvement in the labour market outlook had occurred. Mr Bernanke, in his final year as Fed chairman, was determined to shock the economy into a recovery, in the face of a large fiscal tightening.

These programmes appeared to have profound effects on asset prices, with market sentiment becoming hooked on the details of each new announcement by central banks around the world. Every shade of investor became an expert in the balance of views expressed in the dense minutes of the Federal Open Market Committee.

The growth of the monetary base seemed to be very closely correlated with the performance of equities and other risk assets. Some said that this was only because the asset purchases had powerfulsignalling effects” about the future intentions of the central banks in the area of interest rates, while others took the commonsense view that printing money to buy assets would lead to an artificial rise in their prices.

We still do not know which of these explanations is the right one, but we do know that the rise in asset prices helped to sustain aggregate demand at a time when this was much needed. We also know that it involved large redistributions of wealth in ways which were not intended and are still controversial. Savers lost out as borrowers gained from exceptionally low real interest rates. Some described this as a form of financial repression, a slow form of debt default. And it began to involve bubble-like activity in asset markets, including in emerging market debt and some credit markets.

The Fed has now declared victory, believing that there has finally been a substantial and self-sustaining improvement in the US labour market. It is hard to see how this could have occurred without QE, but the benefits of the policy are now fading. A significant number of FOMC members, led by Jeremy Stein, started to believe that the reach for yield in US credit may have been allowed to proceed too far.

On May 22 the markets began to realise that Mr Bernanke was serious about tapering before the end of this year. The “taper tantrumoccurred. There was a wobble when the Fed refused to act in September, but this is a promise which has now been kept.

It only took the merest hints of tapering in the summer to cause the 10-year Treasury yield to rise by 120 basis points, thus reversing the full effects of QE on the term premium before a single bond had been sold. An interesting development, worrying for the future, is that forward guidance on the path for short rates was not been able to prevent this.

The summer meltdown in emerging markets was a powerful warning shot that the exit may not be painless for markets, though the early indications this week have been that tapering may now be priced in. Many investors currently believe that tapering will be a non-event, with the end of the bull market only being triggered when short-term interest rates begin to rise, heralding a genuine tightening in monetary policy.

A final verdict on QE cannot yet be offered. In its initial stages, it was essential and clearly beneficial. In its middle stages it was still effective, but the effects were not as profound. And in its last phase, it started to have some adverse effects, while the benefits were petering out.

Finally, the exit still has to managed. The Fed does not intend to reduce the size of its balance sheet for several years, and the BoE’s Mark Carney recently said that in the UK the central bank balance sheet may be permanently higher than it was before the crisis. In that event, a part of the budget deficit will turn out to have been permanently monetised, something that has always been vehemently denied by the Fed.

In public, central bankers still sound confident that the exit can be managed as a simple reversal of the entry. Technically, this is valid, but the politics of exit may not by symmetrical to the politics of entry. There is a danger that the independence of central bankers will be compromised when they seek to take actions such as the sale of government bonds which are inconvenient for politicians. In a bad outcome, fiscal dominance over the central bank might yet rear its head.

Quantitative easing has demonstrated to politicians everywhere that it is possible to finance government deficits simply by printing money, a fact which had become obscure in the developed economies in previous decades. The umbilical link, previously unchallenged, between running a budget deficit and the requirement to sell bonds has been broken in the mind of the political system.

Who knows what the long-term effects might be.

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