The unintended consequences of QE: not what you think
By now, everyone is familiar with the mantra that QE is [arghh!] money-printing and that a major unintended consequence could be a chronic and uncontrollable inflation. (One could call this the goldbug, Austrian, Republican case).
Less well known, perhaps, is the theory that QE could be just as unexpectedly deflationary — because long-term micro yields come to threaten a number of financial sectors outright, as well as general expectations of risk-free returns which lead to capital destructive feedback loops.
FT Alphaville readers will be more familiar with this second point, since it's something we've been arguing for a while… (see examples from our compendium on the matter here, here and here, including Cardiff Garcia's epic case against lowering the IOER ).
Yet, it's nice to see that someone from the economic big league is making a similar point.
Case in hand, the latest Federal Reserve Bank of Dallas working paper from William (Bill) White entitled "Ultra Easy Monetary Policy and the Law of Unintended Consequences".
In many ways it's a radical shift in mindset from the central banking arena, not least because of the statement on central bank independence that's made right from the offset (our emphasis):
It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the "independence" of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not "a free lunch", governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level.
What White goes on to suggest is that if asset purchases and ultra low yields do anything, they buy time. They are not, nor ever have been judged, an outright cure.
Ultimately, as time runs out, unintended long-term consequences will inevitably begin to impact. And these, he suggests, could manifest in many forms… deflation included.
Indeed, when it comes to price expectations, there's good reason, says White, to fear the D word just as much as inflation:
A further concern is that the reductions in real rates seen to date, associated with lower nominal borrowing rates and seemingly stable inflationary expectations, might at some point be offset by falling inflationary expectations. In the limit, expectations of deflation could not be ruled out. This in fact was an important part of the debt/ deflation process first described by Irving Fisher in 1936. The conventional counterargument is that such tendencies can be offset by articulation of explicit inflation targets to stabilize inflationary expectations. Even more powerful, a central bank could commit to a price level target, implying that any price declines would have subsequently to be offset by price increases.
However, there are at least two difficulties with such targeting proposals. The first is making the target credible when the monetary authorities' room for maneuver has already been constrained by the zero lower bound problem (ZLB). The second objection is even more fundamental; namely, the possibility that inflationary expectations are not based primarily on central banker's statements of good intent. Historical performance concerning inflation, changing perceptions about the central banks capacity and willingness to act, and other considerations could all play a role. The empirical evidence on this issue is not compelling in either direction.
That end point on central banking, meanwhile, is glaring.
What White seems to be saying is that if and when the QE ruse runs out and the time comes to influence markets through direct price level targeting, it could theoretically be too late.
That's to say there's a good chance that the credibility of the central bank will have been damaged so much, that it will be impossible to sway markets through policy declaration alone.
In short, the central bank will have lost control. And with the central bank not there to steer the economy, there'd be little stopping real-world deflationary forces — if they do exist — from running wild.
White doesn't dismiss the arguments for inflation outright. The bulk of the paper addresses both sides of the argument in equal balance. Yet it's the paper's exploration of the unintended consequences in the financial sector and for central banks themselves, which lean to the deflationary side, which we feel stand out the most.
There's no denying, for example, that extended low yields ultimately spell doom for many of today's financial business models.
As White writes:
Given the unprecedented character of the monetary policies followed in recent years, and the almost complete absence of a financial sector in currently used macroeconomic models, there might well be other unintended consequences that are not yet on the radar screen. By way of example only, futures brokers demand margin, and customers often over margin. The broker can invest the excess, and often a substantial portion of their profits comes from this source. Low interest rates threaten this income source and perhaps even the whole business model. A similar concern might arise concerning the viability of money market mutual funds, supposing that asset returns were not sufficient to even cover operating expenses. A final example of potential problems has to do with the swaps markets, where unexpectedly low policy rates can punish severely those that bet the wrong way. This could lead to bankruptcies and other unintended consequences.
When it comes to central banks, meanwhile, White identifies yet another key risk.
It's possible, he says, that central banks end up cornering the very markets they are trying to reset. In so doing they end up obfuscating important market signals and confusing their understanding of what's really going on:
Third, with central banks so active in so many markets, the danger rises that the prices in those markets will increasingly be determined by the central bank's actions. While there are both positive and negative implications for the broader economy, as described in earlier sections, there is one clear negative for central banks. The information normally provided to central banks by market movements, information which ought to help in the conduct of monetary policy, will be increasingly absent. Finally, with policies being essentially unprecedented, wholly unexpected implications for central banks (as with others) cannot be ruled out.
That this eventually compromises central bank independence is understandable. Government and central banks interests inevitably become completely intertwined.
Yet herein lies the irony. For, if it's clear that low-yield policies and QE buy time, and only time, this inevitably puts the onus on governments, not central banks, to steer the economy out of the path of the unintended consequences of monetary policy.
Indeed, as White concludes:
If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.
Which, by the way, happens to be something that Bernanke and others have been hinting at for a long time.
Related links:
Ultra Easy Monetary Policy and the Law of Unintended Consequences – Federal Reserve Bank of Dallas
The cost of global central bank balance sheet expansion – FT Alphaville
Are western central banks having an existential crisis? - FT Alphaville
Why cutting IOER would be suicidal – FT Alphaville
The base money confusion – FT Alphaville
Sent from my iPad
No comments:
Post a Comment