Peripheral Vision

In the fever of a financial crisis, Quantitative Easing must feel much like a wonder drug to beleaguered central bankers. Nevertheless, some of the long-term the side-effects are pernicious.

What's wrong with it? Well, that rather depends on whether you're coming at the question from a legal, economic, financial, institutional, psychological or socio-ethical perspective. Choose your poison--they're all well-known. From a legal perspective, QE with sovereign bonds sometimes looks a bit like monetary financing (yes, that's a whole different post) and, from an economic point of view, it's a second-best strategy for when interest rates meet the zero lower bound, one with unpredictable consequences that's hard to exit smoothly. As far as the financial markets are concerned, pushing cash into an already cash-rich financial system has all kinds of problematic institutional and structural consequences, including the potential to provoke counterproductive effects, including by increasing banks' assets and putting pressure on the leverage ratio. It also has a tendency to cause market volatility at points of entry and exit. A build-up of dead wood on commercial banks balance sheets in the form of non-performing loans is another well-known feature that tends to come as standard with prolonged QE. From a psychological perspective, QE can give rise to its own dependency behaviours, including the kind of overblown investor risk appetite that comes with too much cash and lower yields in safe haven markets. The socio-ethical problems include the way in which QE uses public resources to push up asset prices, either directly by buying bonds, or indirectly by pushing cash into the stock and property markets, which only benefits those sectors of society wealthy enough to own investments. And, of course, any or all of the above can have knock-on political effects which are unfortunate in and of themselves. So, although we tend to be complacent about QE, it might be better if we thought of it as something more akin to lockdown: a necessary evil, perhaps, but one for which we all pay a high social price. Moreover, the costs mount up and get harder to bear the longer it goes on.

In this regard, part of the problem may be that QE places a tool with powerful market and social side-effects in the hands of central bankers whose job is to nurture the narrow economy by targeting inflation and unemployment. It surely can't be coincidence that the 2007-10 Great Financial Crisis (GFC), with its twin epicentres in London and New York, arrived on the back of a perceived "lack of interest in issues relating to financial markets" at the Bank of England, but even had Old Lady not considered financial stability to be monetary policy's poor relation, refinancing risk in the commercial paper market still would not have made it onto the radar of the Monetary Policy Committee (MPC). That's because the MPC's stand-out priority for Open Market Operations is targeting "low and stable inflation". Monetary policy is not a means of addressing social inequality or even market hygiene. The problem is that, as policy technicians, central bankers tend to deploy tools which have can have a deep and radical impact in these areas.

Even if the economic benefits of QE outweigh the costs when it comes to responding to a crisis, the size of the advantage to be gained by a central bank depends on timing and geography in ways that are not yet wholly clear. For example, the impact on GDP of QE programmes initiated in the US and UK in 2009, in the wake of the GFC, seems to have been greater than the adoption of asset purchases by the ECB following the Euro-area crisis in 2014. Moreover, the effects of the ECB programme on GDP and inflation also appears to have varied from country to country in the Euro-area, with so-called "peripheral" countries seeing a stronger impact. This suggests that the underlying economic fundamentals are key to success and that the degree of "vulnerability" and "stress" at the moment QE is introduced is directly correlated to positive outcomes. It may also suggest that extending QE past the point at which it's needed will not merely prove unhelpful--the deleterious side-effects may actually start to outweigh the positive benefits.

It may be best to think of QE as economic tobacco: calming in a crisis but addictive after a time and destructive in the long-run. And, like tobacco, withdrawal from QE may be highly desirable but also painful and difficult to accomplish. In this regard, the 2013 US Taper Tantrum has left a deep scar on the collective market psyche but the less widely known peripheral effects of terminating QE may be more of a concern. When QE strips the yield away from safe haven assets, investors turn to riskier assets, including equities, corporate bonds and foreign sovereign bonds, particularly in emerging economies. These assets and markets are likely to see turbulence and loss of value if central banks in the world's most advanced economies look to unwind their asset purchase programmes. When a central bank sells assets back into the market, the process is known as Quantitative Tightening or Quantitative Hardening. More accurately, QT involves any process of balance sheet contraction by means of portfolio reduction, including allowing bond purchases to mature without reinvesting the proceeds. The Federal Reserve took this step in November 2017 and gradually stepped up QT during 2018 before reversing course in August 2019, but not in time to prevent cash rates in Repo markets spiking in September 2019 when parties tried to fund their bond auction transactions in a relatively cash-poor environment.

So, now that Federal Reserve officials are starting to talk about talking about taper again, what does that mean? It means, at the very least, that the Fed is about to try and thread a very tricky needle: heading off inflation without causing a damaging credit contraction or creating a volatile, cash-poor financial environment. And if it turns out that the needle starts fighting back, we'll know the truth of Milton Friedman's famous adage: “Nothing is so permanent as a temporary government program”.