The rise of Quantitative Easing (QE) and other so-called Unconventional Monetary Policies has been one of the most important changes to the world in the last decade. Trust me – it’s right up there with the election of Donald Trump and Brexit.
But you could be forgiven for having never even heard of it. And If you have heard of it, odds are that you don’t understand the reasons for it or the mechanism by which it works.
QE is a tool central banks have used to lower long-term interest rates. Because of the massive amount of debt nations took on to bail out their economies after the 2008 financial crisis, lower long-term interest rates were desperately needed to allow this debt to be serviced.
These artificially low long-term interest rates come at a steep cost. They create zombie companies, which slow the growth of the economy – and which many economists blame for Japan’s Lost Decade(s). However, they have allowed the world to avoid a sovereign debt crisis since 2008 (although Italy’s new plan for a parallel currency risks just that).
But the risk from QE isn’t zombie companies – it’s that it is an inherently limited policy. Even if the world was prepared to accept the downsides of permanently low interest rates, eventually central banks will simply be unable to continue the policy. And what happens then?
To understand why central banks cannot continue QE indefinitely – and the incredible risk ending QE presents for a global economy where debt has risen dramatically since 2008 – we need to understand QE and how it works.
Origins of QE
QE first began in Japan. Japan fell into a recession with the strengthening of their currency under the Plaza Accords back in 1985. To combat the recession, Japan unleashed a massive stimulus program, which created a stock market and real estate bubble. When it imploded in 1992, Japan was forced to bailout their financial system.
Because of the massive amount of debt that the Japanese government took on to bailout their economy in the 1990s, the Bank of Japan (BOJ) was forced to begin ryōteki kin’yū kanwa (quantitative easing) in 2001. This quantitative easing policy, or simply QE, was adopted by the rest of the G7 nations following the 2008 financial crisis when they too were forced to take on massive debts to bailout their financial systems.
The quantitative easing engaged in by the major central banks has worked to push down long-term interest rates to unprecedented lows. As economists at the BIS have noted, much of the fall in interest rates over the decades can be explained by demographic factors – i.e. the massive Baby Boomer generation saving for retirement. However, demographic factors alone do not explain today’s ultra-low and even negative interest rates – they are a product of quantitative easing.
There is a great deal of misunderstanding about quantitative easing. Some prominent investors characterized it as printing money and expected it to cause massive inflation. Others have used the lack of inflation as an argument about why sovereign debt doesn’t matter. Neither of these characterizations are accurate. Ultimately, QE is neutral to the monetary base and does not remove government liabilities -although it does lower debt-servicing costs. Former Federal Reserve chair Ben Bernanke has attempted to refute the idea that QE is printing money explaining that:
…sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.
Essentially, the mechanism of QE is that the Federal Reserve and other central banks are buying government bonds – but not directly from the Treasury Department. They’re buying government bonds from banks and paying for them with central bank reserves.
Crucially, these cash reserves are held by the central bank and pay an interest rate just as the treasury bonds did. In a sense the Federal Reserve swapped ten year treasury bonds with hypothetical Federal Reserve Bonds. That’s why you can see a graph of the money supply that shows a massive increase, and yet inflation has not spiked. The money never entered the economy – it is being held in a vault at the central bank (or more realistically is just a number in a spreadsheet). In practical terms it was an asset swap, not a true increase in the money supply. The graphic below shows how QE affects the balance sheets of the banking system, the central bank, and the Treasury in a hypothetical QE process.
QE is essentially an asset swap where the amount of money in circulation remains unchanged. It does not increase or decrease the money supply directly. And neither does it reduce the fundamental debt burden and obligations of governments.
As part of the QE process, the central banks pays the bank interest on excess reserves (IOER) they hold with the central bank. This interest rate is typically very close to the yield on the bonds themselves.
Economists for the Peterson Institute for International Economics and the Federal Reserve Bank of New York explain how this asset swap impacts long-term interest rates. in the 2010 paper, The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases, they describe how:
The primary channel through which LSAPs [Large Asset Purchases – i.e. QE] appear to work is by affecting the risk premium on the asset being purchased. By purchasing a particular asset, a central bank reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held by the private sector. In order for investors to be willing to make those adjustments, the expected return on the purchased security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. This pattern was described by Tobin (1958, 1969) and is commonly known as the “portfolio balance” effect. 69 [emphasis added]
Put more simply, by lowering the total amount of Treasury Bonds available in the private sector the central bank has reduced the amount of safe assets available to investors. With supply reduced and demand unchanged investors will bid the interest rates on government bonds lower. This portfolio balancing effect also impacts other securities. Investors searching for yield will also bid interest rates lower on alternative investments such has highly rated corporate debt etc.
The Inherent Limitation of QE
Importantly though, this is only possible as long as as there are bonds being held by banks. Pension funds or other investors are not eligible to keep reserves at the central bank, and of course banks hold a finite amount of government bonds. Therefore QE cannot be continued indefinitely.
Already the BOJ has begun to run out of eligible bonds to buy – or swap really – for reserves at the central bank. And Ben Bernanke noted in late 2016 that “…constraints on the availability of JGBs [Japanese Government Bonds] were seen in many quarters as limiting the BOJ’s ability to maintain its easy policies beyond the next year or two.” Japan is very close to purchasing all of the outstanding JGBs – at which point it will not be able to continue its QE program.
In Europe, the European Central Bank (ECB) is also approaching a limit to its bond purchases. In September 2016, the Financial Times raised the question “When will the ECB run out of bonds to buy? Warning that the “QE programme could hit a wall as early as this year because of lack of eligible debt.” Although in Europe’s case they are merely running into the rather arbitrary limit of 30% of outstanding bonds that Europe set for itself.
In a 2016 European Parliament report, Limits in terms of eligible collateral and policy risks of an extension of the ECB’s quantitative easing programme, economists Jens Boysen-Hogrefe, Salomon Fiedler, Nils Jannsen, Stefan Kooths and Stefan Reitz acknowledge the inherent limits to a QE program – saying that the ECB must increase it’s bond purchasing limits if it is to continue the program.
Overall, the ECB probably must adjust the limits and criteria for eligible assets if the QE programme is to be extended further[than March 2017]. There are several ways how the ECB could adjust these limits and criteria to significantly increase the amount of eligible assets. However, all of these adjustments would involve the following drawbacks: financial risks would significantly rise, questions of monetary financing would intensify, or market functioning would be put at risk. Moreover, if the ECB continuously changes the limits and criteria this could raise questions whether these limits and criteria have been chosen rather arbitrarily.
The economists also note the risks inherent in the QE program’s attempt to lowering interest rates:
…very low interest rates for an extended period of time stimulate risk-taking (Rajan 2005), potentially fuels asset price bubbles, in turn increasing systemic risks and possibly triggering banking crises. These risks of very expansionary monetary policy tend to increase the longer it is in place (Maddaloni and Peydro 2011,2012). Moreover, very expansionary monetary policy can also trigger the misallocation of real resources and thereby dampen potential growth (White 2012) and hinder necessary adjustment processes in the aftermath of financial crises (Hoshi and Kashyap 2004;Caballero et al. 2008).
The Inevitable End
The ECB, can simply change their own rules and increase the limit on bonds they can purchase – assuming they have the political will which is not a given. But eventually the ECB will purchase all outstanding bonds and reach the ultimate limites of the program. Japan is already very close to their physical limit.
If the BOJ or the ECB was to simply buy bonds directly from the treasury without removing an equivalent amount from circulation by holding it as reserves it would be massively inflationary. It would be the very definition of monetizing debt. QE is an inherently temporary solution. Ultimately, QE can only delay the inevitable rise in the yields on sovereign debt. And while QE has lowered interest rates on sovereign debt and prevented a fiscal crisis up till now, it has come at the cost of distorting the global economy even more than before the 2008 financial crisis.