Axel G. Merk | Jun 15, 2016 10:30AM ET
Are we better off with "QE", the ultra-accommodative monetary policy pursued by major central banks around the world? Is it "mission accomplished" or are we facing a "ticking time bomb"? Are extreme characterizations even warranted to describe the unconventional monetary policy of recent years, and what are implications for investors?
The Good
When interest rates are at or near zero and central bankers want to provide more "monetary accommodation," it is not clear that negative interest rates are the answer. The term "quantitative easing" or "QE" was coined to describe the purchases by of government bonds by central banks. It was combined with "forward guidance", which signaled rates would stay low for an extended period; in our assessment the key goal of both policies was to lower long-term rates (historically, central banks control short-term rates, but leave longer-term rates up to the market to determine). Doing so, the logic goes, would provide the desired "accommodation." There is an index that tries to create a Fed Funds rate incorporating QE:
Note that this index suggests that we have had substantial tightening take place since the 'end' of QE.
Did I just write "the end of QE"? Last time I checked, the Fed had stopped adding to its arsenal of bonds while continuing to reinvest proceeds from maturing securities on its balance sheet. The Fed owns these bonds; that is, they sit on the asset side of the Fed's balance sheet. This is not the place to pass judgment on the methodology of the index, but I want to show how at least some economists look at QE.
It's our understanding that central bankers never want to appear out of ammunition. As such, QE gives them a tool that they believe does the equivalent of 'lowering' rates at any time should, in their assessment, that be warranted.
The Bad
While the Fed's measures may have prevented more firms, possibly even the financial system as a whole, from imploding in the aftermath of the 2008 financial crisis, the economy has hardly fired on all cylinders ever since. Historically, a sharp contraction is usually followed by a steep recovery; this time, however, the recovery has been rather lackluster. Among the reasons for the lackluster recovery may be:
Why the laundry list of possible impediments to growth? With the exception of the first and the last, they have little, if anything to do with monetary policy. Yet, we believe today's breed of central bankers often feels responsible to do whatever they can to help out the economy, even if monetary policy cannot fix the problems at hand. QE might just be too tempting a tool; one, however, that cannot necessarily provide the cure that's needed.
The Ugly
The ugly part comes in when thinking about how to exit QE, if at all. The Fed ought to be focused on inflation and maximum sustainable growth, yet, the Fed to us appears to be increasingly focused on financial markets. Why should the Fed care about how the markets react? A former Fed official told me that the Fed may only need to be concerned about market reaction if it had created an asset bubble. He left it at that without saying that the Fed indeed created an asset bubble.
I would like to take it a step further, though. What happens to all the bonds that central banks have purchased? We hear an increasing number of economists and pundits suggest that this is good news because it effectively reduces government debt, now that the debt has moved from private holders to the central bank. Indeed, we have seen reports that Japan may soon have one of the lowest government debt levels as a percentage of Gross Domestic Product (GDP) given that the Bank of Japan (BoJ) owns an ever-increasing share of Japanese Government Bonds (JGBs). If true, this would be the best free lunch ever served in financial history. Sadly, I very much doubt that this free lunch is digestible. Let me give you two arguments:
First, for purposes of analyzing the impact on an economy, we believe the balance sheet of central banks should be consolidated with that of their government. When the Fed, BoJ or other central banks buys bonds, all they really do is replace long-term obligations (buying bonds) with short-term obligations (cash); that is, they reduce the duration of outstanding government debt. So while the Treasury Department in recent years has diligently tried to take advantage of low rates by extending the average duration of U.S. debt, the Fed has (more than) neutralized their efforts by gobbling up bonds. Think about having a homeowner switch their long-term fixed-rate mortgage to an adjustable rate mortgage. This may work well as long as rates are low, but can cause havoc should rates rise. Importantly, since the central bank sets the rates, it provides an incentive to keep rates lower for longer, potentially causing unintended consequences.
Second, and we have eluded to it before, when a central bank buys bonds, it not only increases the assets on its balance sheet, but double-entry accounting requires that something also increases on the liability side of the central bank's balance sheet. What increases are reserves, notably excess reserves held by banks. That is, banks are sitting on a pile of cash that can be used to support bank lending (as a result of fractional reserve money creation). If there were sufficient demand in the economy, this may provide substantial inflationary fuel. This is one of the reasons we are in 'unchartered' territory. The Fed suggests it can conduct monetary policy through what it calls reverse repurchase agreements, notably by engaging in short-term market operations to reduce liquidity. Our concern is not with the mechanism itself, but foremost the potential political fallout, as they amount to the Fed paying potentially tens, if not hundreds, of billions to financial institutions to incentivize them not to use their reserves to provide loans: an increase in interest rates by the Fed directly translates to the Fed paying, well, interest on its liabilities.
The more sustainable approach, in our assessment, would be to unwind QE, i.e. to let the Fed's bond portfolio roll off or possibly sell its bond portfolio. The Fed could also extricate itself by swapping its bond portfolio with the Treasury department for cash or short-term Treasuries, to allow it to return to more traditional monetary policy faster. Selling bonds on a large-scale may well put downward pressure on bond prices, increasing bond yields, i.e. the cost of borrowing for the government, corporations and consumers alike. And that, in turn, might make government debt levels appear less sustainable, as it would signal a sharp reversal from the seemingly ever lower borrowing costs despite higher absolute levels of government debt.
How Will It End?
Higher borrowing costs are a problem if you have too much debt relative to your income. Governments have a couple of choices, including:
Cutting Expenditures May Include Things Like:
We believe different countries will address these challenges differently; some in potentially increasingly creative or convoluted ways to provide the appearance of legitimacy. In practice, the tough decisions may well need to be imposed by the market, whereas policy makers may increasingly focus on hoping that fiscal spending will get us out of the lackluster growth. Unfortunately I can't help but think of how the Great Depression ended: it was a boost of fiscal spending, all right: the financing of a war. I'm not suggesting any one country will necessarily start a war, but do note that increasing military expenditures in the name of national defense may be more easily passed through the legislature in countries without strong majorities than infrastructure spending. Add to that a rise in populist politicians throughout the world, and we have a mix that suggests to me history may well repeat to those unwilling to learn from it.
I leave it up to the reader to decide whether the Fed and other central banks are part of the problem or the solution. However, I would like to caution that investors may not want to rely on the Fed or the government to take care of their financial well being; they have their own problems cut out for them, as a government in debt may well have their own priorities that run counter to investor interests.
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