How QE became an addiction we must learn to break


There was another goal. The United States responded to the 2008 crisis by recording substantial budget deficits, financed by the issuance of bonds. QE absorbed the bonds about as quickly as they were issued, ensuring yields remained low.

The “bond market vigilantes” who had limited funding to Bill Clinton’s budget were rendered powerless by QE.

In 2013, the Fed planned to gradually unwind QE, but the “taper tantrum” gave it pause. Since then, whenever the Fed has hinted at an outcome, the financial markets have shown their displeasure and the Fed has kept control.

Meanwhile, Japan’s massive quantitative easing program is keeping yen bond yields around zero. Europe did better, turning German yields negative. The UK program gave an additional rationale: QE increases bank reserves, encourages lending and creates more deposits, possibly stimulating demand.

So what’s wrong with QE? Why does the British House of Lords damn him?

COVID-19 added a new rationale in 2020. Very large budget deficits were needed. Lower interest rates were also clearly desirable. Quantitative easing helped ensure that financing larger deficits did not increase bond yields.

In this new environment, even the reluctant Reserve Bank of Australia joined in.

There were some tweaks: Keeping bank financing costs low was a priority, so controlling the three-year bond yield curve was a feature. Falling long yields discourage inflows of international interest rate sensitive capital, which lowers the exchange rate and contributes to international competitiveness.

So what’s wrong with QE? Why does the UK House of Lords see it as a “dangerous addiction”?

The notion of “drug addiction” provides a clue. Something that is beneficial in limited doses in specific circumstances can be dangerous if taken regularly for the long term.

The Fed’s initial QE1 followed tradition – going back to Walter Bagehot in the 19th century – that central banks must support failing financial markets.

But when it continued as QE2, then QE3, it ended up being seen as just a continuation of normal monetary policy.

If the fed funds rate hit the lower bound – where even zero interest rates weren’t enough to stimulate a flabby economy – then the cut in long rates was seen as a mere extension of normal policy.

QE certainly has its supporters.

When central banks’ normal instrument – the short-term interest rate – has done its best, central banks hope to remain relevant in the policy debate with active quantitative easing programs.

For their part, governments which run large budget deficits have reason to welcome the fall in financing costs for QE and to hope for its continuation.

Financial Markets are paying members of the QE fan club. Not only were they saved by QE in 2008, but they have since thrived and developed on the basis of excess liquidity, easily increased whenever the market has a nervous breakdown (2020).

What are the prospects for weaning us from this addiction?

In 2017, then Fed Chairman Janet Yellen said the unwinding of quantitative easing would be like watching the paint dry. From a technical point of view, it is correct. But the diverse pro-QE lobby can turn technical ease into political impossibility.

Allowing unconventional QE to become a routine political tool would be a mistake.

There is a long and unfortunate history of central banks financing budget deficits, overturning the discipline of market financing on libertine governments. QE blurred the important distinction between monetary policy and fiscal policy.

The exercise of political control over interest rates along the length of the yield curve removes useful feedback from the market. Worse, it skews financial decisions – in real and financial investments, asset prices and exchange rates. A cyclical instrument is used for structural purposes.

QE’s largesse in providing liquidity to the market has fostered a bloated financial sector, more interested in casino-style transactions than in facilitating sound portfolio and investment decisions.

Meanwhile, there is so little consensus on the mechanics of QE that former Fed Chairman Ben Bernanke might joke that “QE works in practice but not in theory.”

This week, Fed Chairman Jay Powell may further reveal his take on the future of QE when he delivers the keynote address at the now virtual Jackson Hole meeting of central bankers and economists .

Withdrawal of the cold turkey is not the required prescription. But as the House of Lords concluded, central banks should state precisely what they think QE achieves, how they see its drawbacks, and state their plans for its outcome.

If this is an emergency measure, justified by the 2008 crisis and COVID-19, this transitional aspect must be emphasized to offer a way out and counter those who want unconventional monetary policy to become conventional.

Stephen Grenville is a former deputy governor at the RBA and a non-resident researcher at the Lowy Institute.


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