The reasons for continuing quantitative easing are hard to understand
Monetary policy update
Sign up for myFT Daily Digest and be the first to learn about monetary policy news.
William McChesney Martin, who was chairman of the Federal Reserve from 1951 to 1970, believed that the central bank’s task was to take away the bowl of wine at the beginning of the party.
Investors have been worried in recent weeks that “everything will peak” because of the accumulation of bubbles in stocks, bonds, housing, cryptocurrencies, and God knows what else. The party has already started and is now in full swing and so on.
In fact, central banks have been busy passing their Continue to buy bonds Keep interest rates low while there is endless debate about when and how to withdraw support. Their protest that inflation risks are “temporary” looks increasingly problematic.
The strange thing about this approach to monetary policy is that it seems difficult for the governor of the central bank to explain why he continues to implement the asset purchase plan, called Quantitative easing, Necessary. It is widely believed that the initial injection of liquidity after the 2008-09 financial crisis was invaluable in preventing a 1930s-style depression; similarly, preventing economic disaster after the outbreak of the pandemic last year.
However, central bank officials’ claims that quantitative easing will boost GDP are not convincing. As vaccines have given a clear boost to most advanced economies and asset prices continue to be on the verge of record highs, it is difficult for ordinary people to understand the reasons for continuing to purchase assets. At the same time, unconventional monetary policies are creating greater balance sheet vulnerabilities.
The debt maturity date of the entire public sector balance sheet, including the central bank, has been significantly reduced.
Under the quantitative easing policy, the central bank creates currency by depositing reserves in private banks, which are then used by private banks to purchase government bonds. In effect, the public sector liabilities of government bonds are replaced by reserves created for the purchase of bonds. The impact on the outstanding debt situation is huge.
Bank for International Settlements estimate 15% to 45% of the sovereign debt of all advanced economies is now virtually overnight. In the short term, this will bring net interest savings to the government. But their increased exposure to floating interest rates has increased their vulnerability to rising interest rates.
From the perspective of debt management, non-crisis management quantitative easing only makes sense if the central bank’s policy interest rate remains close to zero during the outstanding debt period. This in turn means great pessimism about economic growth. If interest rates rise, resuming moderately substantial growth will mean very expensive financing.
In advanced economies, the International Monetary Fund estimates that the ratio of government debt to GDP has fallen from less than 80% in 2008 to 120% in 2020. Nevertheless, the interest bill for the debt has declined during this period, which encourages Panglossian’s belief that the debt must be sustainable.
A similar surge in the global non-financial corporate sector caused debt to reach a record high of 91% of GDP in 2019. In this context, investors’ pursuit of returns has led to serious risk pricing errors and widespread capital mismatches.
Monetary policy has become asymmetric, because since the late 1980s, interest rates have never been raised on the upside as they were lowered in the economic downturn. With the accumulation of debt, this leads to an inevitable rise in costs.
The shape of the financial cycle may be changing. In the first four years after World War II, when monetary policy was tightened in response to rising inflationary pressures, the cycle peaked and the recession began. Since then, as inflation stabilized, the financial crisis became the fuse of economic recession.
The current trigger may be a deadly combination of rising inflation and financial instability. The difficulty is that the central bank cannot cancel interest rate hikes and rate hikes without destroying the weak balance sheet and causing damage to the economy.
The temptation for policymakers is to confuse and perpetuate the boom, bust, and bailout cycles. This ultimately leads to a balance sheet recession—a recession caused by a debt burden—to end all recessions. The immediate priority should be to ensure that post-pandemic debt squandering enters productive investment along with planned debt reconstruction and economic re-equalization.