QE Is Not The Answer To Every Economic Problem... It Has Flaws And Inherent Limitations

Since the Global Financial Crisis an increasing number of Central Banks have been purchasing assets, across a wider range of markets. This has inflated a series of bubbles in financial markets and asset prices, from bonds to stocks to property to art to gold... Inequality has worsened, even with the large increase in employment. The main beneficiaries of Quantitative Easing have been the ultra-wealthy (top 0.1% by net assets), highly leveraged investors/structures/promoters, and the plutocracy (the existing elites). QE is inflationary for asset markets and precious metals, but not so much for consumer good and service prices. Enormous stimulus during the coronavirus recession will eventually result in the reflation of risky asset prices, but it will not cause CPI to overshoot targets.

QE is a weak and blunt policy instrument. Like an addictive drug, it's relatively painless to administer but requires greater doses over time (eventually becoming counter-productive). The multiple distortions created by Central Bank intervention mean that many key financial metrics are no longer reliable signals (such as Italian government bond yields being below US Treasury yields, and US$14 trillion of negative yielding debt). Financial theory also breaks down when term premia are annihilated by Central Banks, and QE causes "risk-free assets" to lose their meaning (holders of cash are forced to pay their banks, or bond holders are forced to endure negative returns - either outright or negative real after-tax returns).

According to Federal Reserve data, the top 5% of US individuals own up to 60% of the country's individually-held financial assets. This includes 82% of stock and up to 90% of bonds. So QE really helps the rich, but not the rest of America. The impact of this extreme monetary policy is inequitable:

https://financetrain.com/who-really-benefits-from-quantitative-easing/

Experiments with negative interest rates have had unintended and detrimental consequences. However, the easy path of Central Bank asset purchases is spreading across the developed world like a virus... This implies that yield curves continue converging towards zero, especially for Developed Countries (and others with low inflation). Prices for risky assets will rebound, and they will remain inflated for much of the economic cycle (as they have in Japan for three decades). Lower risk assets with mid-single-digit yield and some growth will continue to attract high demand (such as infrastructure and defensive equities, which have been in a sweet spot in recent years). Debt levels will remain at record highs, and interest rates cannot be lifted (because the economic damage would be catastrophic).

Low and negative interest rates have been a severe headwind to banks (lowering interest margins and reducing the flow of credit to the real economy), insurance providers and pension funds. Many pensioners have relied on interest receipts to fund their cost of living in the past, which has now become impossible. Young people are much less able to accumulate a deposit for their first home, when the real post-tax return on their funds is negative. The prudence of maintaining cash reserves and emergency buffers has been obliterated by Central Bank policies, which push households and companies into further indebtedness... Blaming people for taking on too much debt is contradictory, when that has been the clear signal from policymakers through the whole economic cycle. QE has an inherently high level of moral dilemma.

In recent years there have been many calls for the burden of policy to shift from Central Banks to governments. This was recognition that monetary policy was nearing the lower limits for the conventional policy of interest rate cuts, and was still unable to meet either its mandated inflation target, nor its desire to reach full employment. Fiscal policymakers have essentially outsourced economic management to monetary policy – and it has worked for them for decades (regulators and policymakers have been complacent)...

In Australia, the Reserve Bank continually argued before this crisis that more needed to be done on fiscal policy to get the economy growing at its full potential. As a nation, Australia has relied on population growth and commodity cycles to underpin growth in living standards according to Alex Joiner at IFM Investors. We have relied more on good luck and less on good management. "It was true before this crisis and will be even more so after, that the long-term savings of Australians could be put to better use, particularly in the infrastructure space, to support economic activity, jobs and productivity. Future governments must find a way to access this capital while they work to re-invigorate economic growth in a post-coronavirus world."

https://www.smh.com.au/money/planning-and-budgeting/we-need-new-plan-to-drag-us-out-of-this-economic-mire-20200324-p54ddh.html

The Normalisation of QE: Extreme becomes Conventional

Quantitative Easing (QE) describes a form of unconventional monetary policy in which a Central Bank purchases longer-term securities from the open market, in order to increase the money supply and encourage lending/investment. The Central Bank's balance sheet is expanded by the creation of money in their account, and then assets are purchased from another bank/owner/investor/trader. The Central Bank transfers money to the counter-party, in return for their asset. Systematic intervention in debt markets can allow Central Banks to sculpt the yield curve for government bonds (or other securities), in what is called "Yield Curve Control" where there's an explicit target for long-term interest rates that's set by the Central Bank. Explicit forward guidance is one component of QE (including a target for longer-term yields). The intention of all QE programs is that the debts are repaid, whether by government, banks or corporate borrowers... There are no plans to retire, forgive or cancel this debt. A wider range of assets have been purchased over time: ETFs and REITs in Japan; many credit markets in the US (Mortgage Backed Securities, Leveraged Loans, Bank Loans and Municipal Bonds); European investment grade corporate debt, Covered Bonds (issued by banks and financial institutions) and Asset Backed Securities by the ECB; while the Bank of England has been a large purchaser of corporate bonds...

The adoption of QE across Advanced Economies has been incredibly swift since the GFC, from essentially one-tenth of the Developed World to now about nine-tenths... In early 2008 Japan was the only nation practicing QE (it had 10.5% of the developed population), and by April 2020 about 88% of the OECD population lived in countries that were undertaking QE (Eurozone, UK, Switzerland, Sweden, Poland, Hungary, South Korea, Israel, US, Canada, Australia and New Zealand). The Bank of Japan's balance sheet is already larger than Japanese GDP. Central Bank balance sheets will balloon in size through the Covid-19 recession:

Following the impact of coronavirus restrictions, there has been an unprecedented expansion of QE. Taboos are being broken, including direct lending to the private sector (bypassing the traditional banking sector) as well as public sector debt monetisation (experimenting with Modern Monetary Theory). The US Fed is intervening in every corner of the debt markets (with capacity to do even more if needed), effectively providing a put option on a wide range of US debt securities. Europe has agreed to something resembling Eurobonds (Finance Ministers agreed to use the European Stability Mechanism virtually without conditions). And the Bank of England is temporarily financing fiscal expenditures (allowing the Treasury to overdraft its account for a period of time)... The intent is to prevent a recession from turning into a depression, and to promote as speedy a recovery as possible once the virus is contained.

According to Krishna Guha at Evercore: "In order for businesses and households to increase their debt rather than reduce costs they need to be convinced that when the post-virus recovery comes, the Fed will underwrite a strong rebound in spite of all the well-known challenges delivering stimulus at the zero bound and will prevent any version of a debt-deflation trap. This is about the stance of Fed policy in the future not the stance of Fed policy today. It is not enough to observe that the term structure of rates today is very low – households and businesses need to know rates will stay very low when the recovery comes."

"What we do know is that silly measures like lowering official interest rates are counter-productive and indeed dangerous because they weaken the banking sector. Both the US Federal Reserve and the Reserve Bank of Australia are singing from the same dangerous song sheet." writes Robert Gottliebsen in The Australian on 17 March 2020.

QE has Created Artificial Prices and Large Market Distortions

Central Bank asset purchases and artificially low interest rates have been distorting financial markets since the Global Financial Crisis (and in Japan since March 2001). The last decade has been one of extraordinary monetary policy as Central Bank actions that were put in place in the teeth of the financial crisis have now been a reality for over 10 years. The success or efficacy of QE and negative interest rates is a frequent point of debate, it does help to lower the cost of capital and inflate asset prices. The yields of lower risk assets fall, pushing investors towards higher risk assets:

The current scale of monetary policy intervention is completely unprecedented. There is an absence of yield in almost all asset classes following a decade of Central Bank asset purchases. There had been a low level of corporate bankruptcies, while leverage was growing within listed companies – particularly small cap – and the more rapid growth in leverage in other credit markets.

In essence markets have become almost entirely momentum focused according to UBS, where risk is largely measured as mark-to-market pricing rather than leverage or valuation. The historically high levels of liquidity (accompanied by low rates) do appear to have created an environment in which high levels of leverage are present in a number of markets. Credit protections have been falling every year since the GFC (are we ever going to learn?!).

As always high levels of capital chasing limited investment opportunities will depress returns, and the multiples paid for assets within private markets were back to historic highs prior to the coronavirus recession. A wave of defaults is now likely, and the rising loan impairments will reduce European banks’ already low earnings which have been hit by the negative interest games played the European Central Bank.

We seem to have forgotten the lessons of the credit crunch from 2007-2009. With Central Banks forcing down the cost of debt, many companies and investors have done exactly what was intended: borrow at low interest rates and buy assets to speculate on their future value. Overall debt has never been higher across the World.

There are pockets of excess in Chinese private companies and SoEs, US corporates (especially energy producers and smaller companies), as well as housing debt in Australia, Switzerland, Canada, New Zealand, Denmark, Norway and South Korea. European companies and North American energy producers have been gorging on cheap debt for the last decade. Many companies have borrowed, or repatriated funds, in order to buyback some of their equity. Smaller companies in both Europe and the United States have levered-up during the decade-long expansion following the GFC (and they are at particular risk during the coronavirus recession).

The most fundamental shortcoming of QE is that it only “works” if it somehow induces the private sector to spend more out of current income. Criticism of QE includes the following: additional bank reserves don't enable greater bank lending on their own; interest rate effects are likely to be small when the private sector is attempting to deleverage; purchases of government bonds are simply an asset swap (that reduce the maturity and liquidity of private sector assets but do not raise incomes of the private sector); given the reduced maturity of private sector portfolios, reduced net interest income could actually be mildly deflationary; it brings forward some future investment and consumption (unsustainable growth).

Fullwiler and Wray (2010 Quantitative Easing and Proposals for Reform of Monetary Policy Operations) argue that while there's identical risk to the federal government whether a bailout, a loan or an asset purchase is undertaken by the Fed or the Treasury, there have been enormous, fundamental differences in democratic accountability for the two institutions when such actions have been taken since the GFC began. Public debates surrounding the wisdom of bailouts for the auto industry, or even continuing to provide benefits to the unemployed, never took place when it came to the Fed committing trillions of dollars to the financial system—even though, again, the federal government is “on the hook” in every instance.

Japan Traveled this Path One to Two Decades before Other Countries...

Japan has experimented with aggressive fiscal and monetary policies for three decades. Its Public Sector debt (projected to hit 260% of GDP in 2021), dwarfs public debt in all western economies. The BoJ’s balance sheet is around 108% of GDP. This is more than four times bigger than the comparative size of the Fed’s or the BoE’s balance sheet (prior to the COVID-19 recession) and more than twice as big as the ECB’s. However, a persistent disinflationary mix of economic fundamentals – linked to excess private sector saving and an ageing population - has prevented inflation from ever taking off. Instead, Japanese policymakers have faced deflation rather than inflation risks. Western governments may be surprised at how little inflation expectations rise in the coming months, despite their stimulative actions.

The BOJ had cut short-term interest rates during the 1990s, and maintained cash rates at close to zero since 1999. Under Quantitative Easing, the BOJ flooded commercial banks with excess liquidity to promote private lending, leaving those banks with large stocks of excess reserves and therefore little risk of a liquidity shortage. The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero... Japan was able to maintain high living standards from the bubble of 1989 through until 2008 via a combination of extreme fiscal and monetary stimulus. It helped that their currency was generally weakening, especially during the QE period from 2001 until 2008 (when they were the only country applying QE)... However, nine-tenths of the OECD are now implementing QE as at April 2020. So there's little chance of competitive devaluation, since FX is a zero-sum game at the World level. Only the most extreme Central Bank asset purchases have the best chance of depressing their currencies at present.

During the early 2000s I was covering Japanese equities at BT Funds Management, researching and analysing the Telecom, Transport and Utility sectors. Having recently completed Bachelor degrees in Economics and Commerce, I was blown away by the absence of risk premia, distorted yield curves and artificially low interest rates... The combination of extreme monetary easing, coordinated fiscal policy and a managed currency was completely at-odds with a classic education in macroeconomics and finance. The lack of term premium for government bond yields, lack of Central Bank independence, and not being beholden to credit rating agencies or the discipline of external capital providers...

QE Is Spreading to More Countries, and to More Asset Classes

China has their own version of Quantitative Easing. The People Bank’s of China (PBoC) has decided to facilitate their banks’ task in two ways: first, by providing cheaper liquidity to banks lending to the private sector; and secondly, by facilitating banks’ efforts to increase their capital base. In fact, with what could be considered a very bold move, with some resemblance to the Quantitative Easing of major central banks globally, the PBoC has announced that it will acquire (or more precisely, swap for three years) the perpetual bonds that Chinese banks’ will issue to beef up their capital.

https://www.bruegel.org/2019/03/chinas-debt-is-still-piling-up-and-the-pile-up-is-getting-faster/

The Brazilian Congress is currently debating a bill to grant their Central Bank emergency powers to carry out QE as part of its crisis-fighting arsenal, allowing it to buy public and private financial assets during national emergencies. This sets the path for a cautious introduction to QE, rather than immediate and aggressive asset purchases.

Even though Russia has criticised Western countries for adopting asset purchases, the Russian Central Bank's new loan facility was hailed as “a form of Quantitative Easing” by their country's Economy Minister in July 2013.

The case for QE in India is getting stronger, but there are challenges for forcing down interest rates when inflation is at 7%.

In January this year an article in The Conversation argued that "Quantitative Easing now looks permanent – and has turned central banks into pseudo governments". By choosing which debt (and sometimes equity) markets to intervene in, Central Banks have taken on increased political importance:

https://theconversation.com/quantitative-easing-now-looks-permanent-and-has-turned-central-banks-into-pseudo-governments-130098

In Conclusion

A dozen years ago Quantitative Easing was an unusual policy, only being applied in one country. Today QE is being implemented across 90% of the OECD. Central Bank asset purchase programs have been highly inequitable (benefiting elites and the richest asset owners at the expense of everyone else). The policy tool is relatively weak and is blunt, it has inflated financial markets/asset prices without achieving inflation/employment targets. Leverage and excesses have built-up since the GFC. Central Banks have been drawn into politics and their independence from Government has been significantly reduced. QE has distorted key market signals, which were relied upon for many decades. Accepting Quantitative Easing as a mainstay of monetary policy will lock the world into ever higher debt and low interest rates for decades to come… Is that socially beneficial or sustainable?