A constant concern over the past few years has been that quantitative easing (QE) or “money printing” won’t do anything to help economic growth. Rather, some fear it is preventing a proper cleansing of the economic system, repressing bond yields, artiﬁcially inﬂating share markets and blowing new asset bubbles, creating currency wars and will ultimately end in hyperinﬂation. Reﬂecting all this, some warn – with almost a zealot like fervour – of a coming economic collapse and how gold will be the only protection (along with a can of baked beans and a semi-automatic riﬂe).
We are now more than four years into quantitative easing in the US and elsewhere and the much feared problems haven’t appeared. But this hasn’t stopped many from prophesising an inevitable doom. This note looks at the key issues and tries to put some of the concerns in context.
What is quantitative easing and why do it?
Quantitative easing basically involves a central bank such as the US Federal Reserve (Fed) using printed money to buy assets such as government bonds or mortgage-backed securities (ie pools of mortgages) in order to pump cash into the economy
Normally central banks implement monetary policy by changing interest rates. But when companies and households are focussed on reducing debt, interest rates can fall to zero and still growth remains weak. To continue boosting the economy another way is to boost the quantity of money. Hence the quantitative easing since the global ﬁnancial crisis.
How does QE work to boost growth?
There are several channels through which quantitative easing can boost growth. First, by pumping money into bond and mortgage markets it lowers long-term borrowing costs. Second, by injecting more cash into the economy – mostly into the banking system – some of this may be lent out, boosting growth. Third, by displacing investors in risk free assets such as government bonds it forces private investors to invest more in risky assets such as corporate bonds or shares which boosts the supply of capital to businesses.
Fourth, to the extent that it boosts share markets it boosts wealth, which in turn helps drive spending. Finally, an increase in the supply of a particular currency, say the US dollar or yen as a result of quantitative easing, may reduce its value making it easier for exporters.
Is QE working?
It is well known that monetary policy cannot solve structural problems in an economy. But like a drip feeding into a patient in a coma it can keep it alive until enough healing has occurred. This appears to be what is happening in the US. QE has prevented a likely worse economic collapse and in the meantime the US economy gradually appears to be getting stronger with a housing recovery leading the way.
What are the risks associated with QE?
There are several risks associated with quantitative easing. These relate to the difﬁculty in ensuring a smooth exit once it is no longer required, ﬁnancial distortions associated with the central bank owning a signiﬁcant share of the bond market, asset bubbles and inﬂation. At present the beneﬁ ts in the form of lower unemployment and higher growth appear to outweigh the costs. So far it’s hard to ﬁnd any asset bubbles – although gold and bonds been have and remain potential candidates – but history tells us that it isn’t just QE that can lead to bubbles. Historically, monetary easing via interest rate cuts have also often led to bubbles. And there is still no sign of any hyperinﬂation. But obviously the tradeoff between the beneﬁts and the costs needs to be looked at carefully.
Is there more to the share rally than QE?
Successive rounds of quantitative easing in the US since 2009 have been associated with rises in US shares and this has ﬂowed through to global share markets. However, it would be wrong to say this is the only factor driving shares higher. US shares are around record highs but this is underpinned by record proﬁ ts in the US. See the next chart.
US shares around record highs, but proﬁts even better
So, as in other countries, while price-to-earnings ratios have gone up over the past year as economic risk has declined, they are not at expensive levels and are well below their peaks in 2000 and 2007. There is no sign of any bubble here. Similarly, although property prices have started to recover, in the US and other countries using quantitative easing it’s hard to argue that they are in a bubble.
But is QE repressing bond yields?
With the Fed buying bonds it is natural to argue that yields are being artiﬁ cially suppressed. However, the Fed still only owns just over 10% of the stock of US bonds and given the severity of the economic slump it’s doubtful whether rates would be any higher than they currently are:
With US gross domestic product (GDP) around 6% below its long term trend and inﬂ ation around 2%, interest rates should be low. An approach used by economists is the Taylor Rule which says short-term interest rates should equal the current inﬂ ation rate plus the equilibrium real rate, adjusted for the amount by which inﬂ ation is below target and activity below trend. For the US this is now around zero.
With short rates around zero, 10 year bond yields around 2% are not out of line.
Additionally, abundant savings and weak credit demand is also likely pushing long-term borrowing costs down.
In other words bond yields are probably not far from where they would otherwise be. This is not to say bond yields won’t rise as growth picks up or that they offer great value for investors. Rather, they are probably not distorted by QE.
What about the lack of cleansing?
There is the argument that free market forces should be able to run their course in order to allow a proper cleansing of the ﬁnancial system of its past excess associated with debt. However, the problem is that it ignores the role of free market forces in causing the problem in the ﬁ rst place. Also it ignores the likelihood that if free market forces are able to run their course, numerous innocent bystanders will be adversely affected. The 1930s was a classic example of this where for various reasons the US Government and the Fed stood by and oversaw a 54% collapse in industrial production and the demise of hundreds of banks and 20% plus unemployment. So there is a case for monetary policy to smooth any adjustment in debt levels.
What about currency wars?
The term “currency wars” is really nonsense. All countries when they go through tough times provide monetary stimulus to get their economies on track. This normally involves lower interest rates, but more recently QE. Both can have the effect of depressing the country’s exchange rate. But this is nothing new. It should really be called stimulus wars. In fact the world would be far worse off if the US and other countries hadn’t applied QE – growth would have been lower which would have made life even tougher for emerging countries and commodity exporters.
What happened to hyperinﬂation?
For the past few years we have heard incessantly that hyperinﬂ ation was coming in the US thanks to money printing. Some were saying the US was set to become the next Zimbabwe. But US inﬂ ation is 2%. What happened?
US narrow money supply has surged, broad money has not
The basic mistake on the part of those foreseeing hyperinﬂation was to confuse an increase in narrow measures of money, such as cash and bank reserves (the monetary base) with broader money supply measures, namely M2 and credit. While narrow money has surged 250% since the start of 2008 thanks to QE, M2 is up just 39%, or at a benign annual rate of 6.5%. See previous chart.
And it’s these broader measures that need to increase pace signiﬁcantly if inﬂ ation is going to pick up. This is only going to happen if the banks start lending out their reserves big time, and whilst there has been a pick up in bank lending it’s hardly surging. What the Fed has effectively done is prevent a 1930s style collapse in the broadly deﬁ ned money supply – but it hasn’t yet caused a big increase in it.
And all the spare productive factory and labour market capacity in the US and elsewhere needs to be used up, such that ﬁ rms have more ability to raise prices for inﬂ ation to really take hold. But again this seems a fair way off as US unemployment remains high and GDP is running well below trend levels. See next chart.
There is plenty of spare capacity in the US and globally = hard to see inﬂation picking up just yet
So until broad money and bank lending increases signiﬁcantly and spending increases such that spare capacity is used up then I would not be too concerned about inﬂation.
What about inﬂation risks generally?
This is not to say inﬂation is not a risk. Over the past 30 years we have seen falling and low inﬂ ation. However, the next chart highlights a 20-30 year cycle in inﬂ ation. After a long bout of falling inﬂ ation, the risks will start to shift to rising inﬂation if the global economic recovery gathers steam such that spare capacity is used up and if central banks like the Fed are too slow in withdrawing the stimulus.
Inﬂation since 1900 - is the cycle close to bottoming?
Concerns about QE driving economic mayhem, currency wars, hyperinﬂation, etc, are overblown. In fact, if it was not for QE, global growth would be lower. However, the broader risk is likely to shift towards inﬂ ation in the years ahead.
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