QE unwind must be on the money

While QE has so far been successful – and misunderstood – the longer the abnormal price signals of low interest rates persist the more dangerous its unwinding will be.

Lowy Interpreter

The initial response to Japan's new monetary policy has been dramatic. Even before any action has been taken, the exchange rate has depreciated by 20 per cent and equity prices are up 30 per cent. People are talking as if the lost decades are over. Others, however, are arguing that quantitative easing shouldn't be repeated too often.

Some critics just don't understand how it works. The often-heard argument is that QE is 'printing money' and, based on Milton Friedman's teaching, they know that money causes inflation. This is wrong.

Let's leave the money/inflation debate to one side and just note that QE doesn't involve 'printing money', at least not literally. The latest IMF Global Financial Stability Report has a nice graph illustrating the point (see above). Put together the red bit (the Fed's bond buying) and the pink bit (the Fed's purchase of mortgage-backed securities) and you have a good measure of QE. This is symmetrically offset on the other side of the Fed's balance sheet by the blue section, which is commercial banks' deposits with the Fed.

QE didn't have any noticeable impact on money printing (the bluey-grey bit, currency, just jogs along on trend). The extra liquidity flowed into the banks' balance sheets, but they had nothing better to do with these funds than to put them on deposits at the Fed: pretty much a round-robin.

This is not to say that QE was without effect: the market took QE as a sign that the Fed cared about the state of the economy and would keep interest rates near zero for quite some time. This helped the stock market and lowered the exchange rate.

So far so good. As noted, the same thing has now happened with the Abe initiative in Japan: the financial market likes it. So what is there to worry about?

There are some issues while this 'monetary policy plus' is in force. Low interest rates cut the income of pension funds (and pensioners). While low interest rates help banks and companies repair their balance sheets, this may at the same time take pressure off firms to restructure. Cheap borrowing might facilitate projects which will no longer be viable when interest rates rise. Low exchange rates have been a source of discontent for countries on the other side of the rate, who have seen their currencies lose competitiveness. In short, there are some concerns, though nothing demanding immediate reversal of QE.

Looking ahead, does unwinding QE present concerns? While there is no mechanical reason why QE itself should boost inflation in economies which still have significant spare capacity, if the demand for credit picks up, central banks will have to rein in this demand by raising interest rates. This is never popular ('taking away the punch bowl just when the party gets going'). Thus risk number one is that these central banks will be slow to raise interest rate when the time comes. This is a serious issue, but not imminent.

Do they need to reverse all the QE to keep a tight monetary rein? No, as they can keep the excess reserves firmly locked in the banks' balance sheets by offering a sufficiently attractive interest rate on these deposits.

The more serious concerns centre on how the economy would react to a higher interest rate, having gone so long (five years and still counting) with historically very low interest rates. It's not just the short-term policy-determined interest rates that would go up. Long-term interest rates are extraordinarily low in many countries. In theory the market has already built this into its plans and prices. But based on the US experience of 1994, even inevitable interest rate rises come as a discombobulating surprise to financial markets. We used to believe that financial markets were forward-thinking and risk-aware, but 2008 disabused us of this view.

Where would the damage occur? When longer-term interest rates rise, bond-holders make a capital loss. A 1 per cent rise would cut the value of the US Fed's bond portfolio by 8 per cent. For the Bank of Japan the losses are smaller now, because the long-term bond-buying has not started, but this vulnerability is about to rise sharply. As well, Japan's commercial banks have one-quarter of their balance sheets invested in government bonds.

Moreover, budgets will take a big hit. Japanese government debt is 240 per cent of GDP, so a 1 per cent rise in interest rates will, in time, add 2.4 per cent of GDP to budget expenditures. So if the BoJ succeeds in raising inflation to 2 per cent and long-term bonds respond, Japan has another set of problems on its hands.

The QE experience has been an amazingly bold policy initiative, justified only by the intractable nature of this crisis, where conventional monetary policy has been pushed to the limit and fiscal policy has been sidelined because of debt concerns. But the longer the abnormal price signals of low interest rates persist, and the more balance sheets are distorted by QE, the more disruptive the unwinding of 'monetary policy plus' will eventually be.

It is building confidence and buying time for other policies to work, but in most cases this time is being frittered away without addressing the basic problems: unsustainable debts in the European periphery which need to be written off rather than rescheduled, fiscal deadlock in the US and unaddressed structural problems in Japan.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.

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