QE: More bang than buck

Despite the hype, the effects of quantitative easing on the US economy are quite limited, and also laced with trade-offs.

Lowy Interpreter

As soon as Fed Chairman Ben Bernanke announced a third round of 'quantitative easing' – QE3 – economic commentators reported it as another episode of 'money printing', with newspapers illustrating the story with pictures of piles of currency. There is plenty of room for uncertainty about the impact of this decision, but one thing is certain: it will not make much difference to the amount of currency in circulation.

The pace of growth of currency in circulation during the QE1 and QE2 period (from late-2008 until the middle of 2011) was much the same as it had been for the previous decade, and the same as it has been since QE2 ended. Thus there is no need to worry that QE3 might cause inflation via 'too much money chasing too few goods'.

The possible channels of effect are more subtle. QE involves the Fed buying financial assets (usually government bonds), with the Fed's payment for these bonds being credited to the sellers' bank accounts. Thus it is deposits, not currency, that rise initially.

The bond purchase should tend to bid up the price of bonds, thus lowering the yield. The stimulus from this lower interest rate was initially put forward as the main channel through which QE would operate. But in practice it has been hard to detect much effect of either QE1 or QE2 on interest rates, although of course we don't know the counterfactual: what would have happened without the Fed's action.

Bond yields were just over 3 per cent when QE1 was announced in November 2008 and were just over 3 per cent when QE2 finished in mid-2011. Since then bond interest rates have fallen to historically low levels, but this fall took place when QE was not operating. When QE2 ended, bond yields were still over 3 per cent and have halved since then, without any QE operations.

Thus we need to look elsewhere for the impact. The bond sellers found themselves with increased deposits, which might have encouraged them to repay bank loans, with little or no effect on economic activity. Or they might have bought other assets, bidding up these prices. Each QE operation has raised equity prices, which might reflect this effect. Just as likely, it might reflect the general boost to confidence which comes from the Fed's signal that 'it cares' and that it will go on working hard to try to get the economy moving faster.

Even though the QE operations didn't have much effect on the public's currency holdings, they did sharply raise banks' excess deposits at the Fed. As a result of these large holdings of low-return assets, it's possible that banks might have tried harder to find borrowers. But banks were already meeting the borrowing demands of bankable customers, and with interest rates already very low, there was no demand for new loans.

The latest version of QE has a couple of twists that might help. In QE1, the Fed bought not only government bonds but also privately-issued mortgage-backed securities. At the time (early 2009) this market had frozen because of lack of confidence in these assets, and the Fed's action was probably beneficial in getting this market going again. This time round, they will resume buying MBSs rather than the government bonds that they bought in QE2. But the MBS market is no longer frozen so the effect, while probably still beneficial in putting downward pressure on mortgage interest rates, is likely to be less powerful than in 2009. In any case, there are more micro-factors which are holding back housing.

Some commentators are making much of the fact that the Fed's promise is 'open ended', continuing until the economy is in a healthier state, with lower unemployment. But it would take nearly four years of QE3 operations at the planned rate for this episode to match the volume done in the first two QEs, so this doesn't seem a big story.

This promise to continue operations should push down medium-term interest rates, not just the short-term rates that the Fed's actions normally target. But the Fed had already made a promise to keep interest rates very low until at least the end of 2014 (and this promise has now been pushed out to mid-2015). Again, there doesn't seem a big extra effect from QE3.

QE announcements have consistently lowered the US dollar exchange rate a little, and this should boost net exports. But of course this is at the expense of foreign competitors, so it risks reigniting the 'currency wars'.

What should we make of all this? Bernanke has always talked as if QE is a powerful instrument. He quotes studies confirming this: past QEs might have added 3 per cent to growth and two million to employment. But these studies are done by the 'official family' and it's not in anyone's interests to say that the magic doesn't work. Bernanke did, however, say that other instruments of policy also had to be mobilised to get the economy going. "Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralise the fiscal and financial risks that the country faces."

But if QE is such as powerful instrument, why hasn't it been used more? It's not, as some argue, that all this 'money printing' will suddenly spring back to cause inflation. But there is not much doubt that the Fed, like all central banks, is uncomfortable treading the fine line between fiscal and monetary policy and dislikes long periods of very low interest rates, which distort investment signals, undermine pension plans and hurt those who rely in investment income.

There may not be a serious technical problem in unwinding QE when the time comes, but there is always a political issue when interest rates have to be raised. When this happens, those holding bonds (including the Fed) will experience significant capital losses. Those who believe QE is a powerful instrument argue that the benefits outweigh the costs. But those who remain unconvinced by the purported channels of operation, and who think it has mainly worked by boosting confidence through incantation, don't want to see the monetary magic performed too often for fear that the audience will see that it is largely a matter of smoke and mirrors.

Then there is the politics. If this helps the economy, then it helps Obama. Romney can't oppose action which fosters a sustained economic recovery, but he can (and does) claim that this is politically-motivated 'sugar-high', lasting just long enough to get Obama over the line.

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