Ten QE ques­tions

The Pak Banker - - OPINION -

MOST ob­servers re­gard un­con­ven­tional mon­e­tary poli­cies such as quan­ti­ta­tive eas­ing (QE) as nec­es­sary to jump-start growth in to­day's anaemic economies. But ques­tions about the ef­fec­tive­ness and risks of QE have be­gun to mul­ti­ply as well, in par­tic­u­lar, 10 po­ten­tial costs as­so­ci­ated with such poli­cies merit at­ten­tion.

First, while a purely ' Aus­trian' re­sponse (i.e. aus­ter­ity) to burst­ing as­set and credit bub­bles may lead to a de­pres­sion, QE poli­cies that post­pone the nec­es­sary pri­vate­and pub­lic-sec­tor delever­ag­ing for too long may cre­ate an army of zom­bies: zom­bie fi­nan­cial in­sti­tu­tions, zom­bie house­holds and firms, and, in the end, zom­bie gov­ern­ments. So, some­where be­tween the Aus­trian and Key­ne­sian ex­tremes, QE needs to be phased out over time. Sec­ond, re­peated QE may be­come in­ef­fec­tive over time as the chan­nels of trans­mis­sion to real eco­nomic ac­tiv­ity be­come clogged. The bond chan­nel doesn't work when bond yields are al­ready low; and the credit chan­nel doesn't work when banks hoard liq­uid­ity and ve­loc­ity col­lapses. In­deed, those who can bor­row (high-grade firms and prime house­holds) don't want or need to, while those who need to - highly lever­aged firms and non- prime house­holds - can't, ow­ing to the credit crunch. More­over, the stock-mar­ket chan­nel lead­ing to as­set re­fla­tion fol­low­ing QE works only in the short run if growth fails to re­cover. And the re­duc­tion in real in­ter­est rates via a rise in ex­pected in­fla­tion when ope­nended QE is im­ple­mented risks even­tu­ally stok­ing in­fla­tion ex­pec­ta­tions.

Third, the for­eign- ex­change chan­nel of QE trans­mis­sion - the cur­rency weak­en­ing im­plied by mon­e­tary eas­ing - is in­ef­fec­tive if sev­eral ma­jor cen­tral banks pur­sue QE at the same time. When that hap­pens, QE be­comes a zero-sum game, be­cause not all cur­ren­cies can fall, and not all trade bal­ances can im­prove, si­mul­ta­ne­ously. The out­come, then, is ' QE wars' as prox­ies for ' cur­rency wars'.

Fourth, QE in ad­vanced economies leads to ex­ces­sive cap­i­tal flows to emerg­ing mar­kets, which face a dif­fi­cult pol­icy chal­lenge.

Ster­ilised for­eign- ex­change in­ter­ven­tion keeps domestic in­ter­est rates high and feeds the in­flows. But un­ster­ilised in­ter­ven­tion and/ or re­duc­ing domestic in­ter­est rates cre­ates ex­ces­sive liq­uid­ity that can feed domestic in­fla­tion and/or as­set and credit bub- bles. At the same time, for­go­ing in­ter­ven­tion and al­low­ing the cur­rency to ap­pre­ci­ate erodes ex­ter­nal com­pet­i­tive­ness, lead­ing to dan­ger­ous ex­ter­nal deficits. Yet im­pos­ing cap­i­tal con­trols on in­flows is dif­fi­cult and some­times leaky. Macro­pru­den­tial con­trols on credit growth are use­ful, but some­times in­ef­fec­tive in stop­ping as­set bub­bles when low in­ter­est rates con­tinue to un­der­pin gen­er­ous liq­uid­ity con­di­tions.

Fifth, per­sis­tent QE can lead to as­set bub­bles both where it is im­ple­mented and in coun­tries where it spills over. Such bub­bles can oc­cur in eq­uity mar­kets, hous­ing mar­kets ( Hong Kong, Sin­ga­pore), com­mod­ity mar­kets, bond mar­kets (with talk of a bub­ble in­creas­ing in the United States, Ger­many, the United King­dom, and Ja­pan), and credit mar­kets (where spreads in some emerg­ing mar­kets, and on high-yield and high-grade cor­po­rate debt, are nar­row­ing ex­ces­sively).

Although QE may be jus­ti­fied by weak eco­nomic and growth fun­da­men­tals, keep­ing rates too low for too long can even­tu­ally feed such bub­bles. That is what hap­pened in 2000-2006, when the US Fed­eral Re­serve ag­gres­sively cut the fed­eral funds rate to 1 per cent dur­ing the 2001 re­ces­sion and sub­se­quent weak re­cov­ery and then kept rates down, thus fu­el­ing credit/hous­ing/sub­prime bub­bles.

Sixth, QE can cre­ate moral­haz­ard prob­lems by weak­en­ing gov­ern­ments' in­cen­tive to pur­sue needed eco­nomic re­forms. It may also de­lay needed fis­cal aus­ter­ity if large deficits are mon­e­tised, and, by keep­ing rates too low, pre­vent the mar­ket from im­pos­ing dis­ci­pline.

Sev­enth, ex­it­ing QE is tricky. If exit oc­curs too slowly and too late, in­fla­tion and/or as­set/credit bub­bles could re­sult. Also, if exit oc­curs by sell­ing the long-term as­sets pur­chased dur­ing QE, a sharp in­crease in in­ter­est rates might choke off re­cov­ery, re­sult­ing in large fi­nan­cial losses for hold­ers of long-term bonds. And, if the exit oc­curs via a rise in the in­ter­est rate on ex­cess re­serves (to ster­il­ize the ef­fect of a base-money over­hang on credit growth), the en­su­ing losses for cen­tral banks' bal­ance sheets could be sig­nif­i­cant. Eighth, an ex­tended pe­riod of neg­a­tive real in­ter­est rates im­plies a re­dis­tri­bu­tion of in­come and wealth from cred­i­tors and savers to­ward debtors and bor­row­ers. Of all the forms of ad­just­ment that can lead to delever­ag­ing (growth, sav­ings, or­derly debt re­struc­tur­ing, or tax­a­tion of wealth), debt mon­eti­sa­tion (and even­tu­ally higher in­fla­tion) is the least demo­cratic, and it se­ri­ously dam­ages savers and cred­i­tors, in­clud­ing pen­sion­ers and pen­sion funds.

Ninth, QE and other un­con­ven­tional mon­e­tary poli­cies can have se­ri­ous un­in­tended con­se­quences. Even­tu­ally, ex­ces­sive in­fla­tion may erupt, or credit growth may slow, rather than ac­cel­er­ate, if banks - faced with very low net in­ter­est-rate mar­gins - de­cide that risk rel­a­tive to re­ward is in­suf­fi­cient.

Fi­nally, there is a risk of los­ing sight of any road back to con­ven­tional mon­e­tary poli­cies. In­deed, some coun­tries are ditch­ing their in­fla­tion- tar­get­ing regime and mov­ing into un­charted ter­ri­tory, where there may be no an­chor for price ex­pec­ta­tions. The US has moved from QE1 to QE2 and now to QE3, which is po­ten­tially un­lim­ited and linked to an un­em­ploy­ment tar­get. Of­fi­cials are now ac­tively dis­cussing the merit of neg­a­tive pol­icy rates. And pol­i­cy­mak­ers have moved to a risky credit-eas­ing pol­icy as QE's ef­fec­tive­ness has waned.

In short, poli­cies are be­com­ing more un­con­ven­tional, not less, with lit­tle clar­ity about short-term ef­fects, un­in­tended con­se­quences, and long-term im­pacts. To be sure, QE and other un­con­ven­tional mon­e­tary poli­cies do have im­por­tant short-term ben­e­fits. But if such poli­cies re­main in place for too long, their side ef­fects could be se­vere - and the longer-term costs very high.

Newspapers in English

Newspapers from Pakistan

© PressReader. All rights reserved.