The great quantitative easing experiment was a mistake. It's time central banks acknowledge it for the failure it was and retire it from their policy arsenal as soon as they’re able.
Since the global financial crisis of 2008, an integral part of central banks' play book in the US, the UK and the European Union has been QE — the practice of buying up long-term bonds and mortgage-backed securities. QE is supposed to work by lowering long-term interest rates, which boosts demand and increases lending and risk-taking.
There is little to show in terms of the economic benefits of QE, but there are plenty of costs. Now central banks find their hands tied as they try to curb inflation with interest rate increases and quantitative tightening, which means no more purchases of long-term bonds and mortgage-backed securities. But they're finding that ending QE can itself be a threat to financial stability.
During the 2008 financial crisis, central banks were desperate to inject liquidity into the financial system. With the policy interest rate at zero, it needed to figure out another mechanism, so it bought long-term bonds and mortgage-backed securities, ballooning its balance sheet. That was supposed to be an emergency measure, but it went on for years. QE was followed by QE2 and then QE3 as the Fed became fearful that stopping would crash the bond markets.
About a decade later, just as the Fed’s balance sheet finally started to shrink, along came the pandemic and the biggest QE ever. It lasted well after the immediate crisis passed, even as inflation and the housing market started to heat up.
Looking objectively at the evidence, it's still not clear that all this bond buying ever did much for the economy. As Ben Bernanke once said, “The problem with Quantitative Easing (QE) is that it works in practice but not in theory.”
In cases where a market is in trouble, having the central bank step in and buy bonds can provide needed liquidity. But using QE to boost the entire economy, to lower unemployment or boost inflation, has a more dubious record. One study, called Fifty Shades of QE, assessed the many research papers that measure the impact of QE on the economy. It found that all the research coming from central banks view QE as a great success, but only half of the research from academics finds any benefits to economic output or inflation. When they do find some benefit, it tends to be smaller than the bank research claims.
Meanwhile, there are substantial costs. First there are direct costs: QE is essentially taking a leveraged bet that won't pay off if interest rates increase. The Fed pays interest on the reserves it holds for banks, and it uses those reserves to finance its purchases of long-term bonds. Now that the interest rate has increased to fight inflation, the Fed must pay more for reserves than it's getting from the bonds in its portfolio, and it’s losing money.
The indirect costs of QE could be even worse. Using QE to keep interest rates low distorts risk assessment since bonds are considered the risk-free assets in the economy — they're used to price assets and act as a barometer on risk-taking. Long-term bonds are among the most systematically important assets in the economy, and when their price is distorted, risk prices have less meaning.
The Bank for International Settlements published a paper arguing that lowering long-term rates made corporate debt cheaper, which propped up zombie companies. The Fed’s interference in the mortgage-backed-securities market during the pandemic may distort the housing market for years.
Hanno Lustig, a finance professor at Stanford's business school, is concerned that suppressing government borrowing rates “jams the signal” markets would otherwise give when the government is borrowing too much. "Bond traders have an incentive to invest more in figuring out what the central bank will do, less in figuring out what the [market] fundamentals are,” he said.
QE blurs the relationship between fiscal and monetary policy and threatens central bank independence because the Fed is essentially monetizing government debt. It also makes it very hard to follow monetary policy rules.
There was a long-running debate among macro economists over how the Fed should do monetary policy. Should it just respond to conditions as they unfold, depending on the monetary policy currently in fashion? Or should it follow pre-set rules based on data, such as setting the interest rate with a formula that accounts for inflation, unemployment and GDP.
Many economists think rules are better in most situations because they maintain the Fed’s credibility and promote transparency. There is no such formula or rule for QE; it's always ad hoc. That may be necessary in an emergency like the financial crisis. But the persistent use of QE shows central bankers will then extend that emergency action into normal times.
Ending QE won’t be easy. Central banks now have enormous balance sheets that will take years to whittle down. And as we see in the UK, when a central bank stops buying bonds, it can throw markets into chaos. Now that QE has become the norm, the next time there is a recession markets will expect more QE, and if doesn’t happen that could cause more trouble in the debt market.
That’s why central banks need to admit QE was a mistake. Their credibility is already at stake after they underestimated inflation. Now is the time to take a hard look at monetary policy over the last decade and rethink what worked and what didn’t. Otherwise we’ll be stuck with QE forever.
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