QE wouldn’t have made any difference because lower rates won’t fix the economy

The big news in the US today was the Federal Reserve’s Open Market Committee’s decision to extend its simultaneous purchase of longer-dated Treasuries and sale of shorter-dated ones. This effort, dubbed Operation Twist, was set to expire at month’s end and so, with weakening growth in the US, the Fed decided to lengthen the program through the end of the year. The FOMC decided to keep the operation relatively small, opting for $267bn. This intervention comes after the Bank of England’s minutes revealed that the BOE narrowly decided not to continue its quantitative easing program. Expectations are that the BOE will go QE next month.

But with both mortgage and interest rates in the US and the UK at record lows, one must ask whether QE makes any sense. In my view it does not. In particular because any effects through the interest income channel in the form of lower borrowing costs for debtors is offset by the loss of interest income for savers. The conventional wisdom is that lowering rates spurs the economy by increasing credit demand. But in this particular recession, we are seeing that this effect is offset by the decrease in interest income and that’s without having to worry about the potential misallocation of resources that easy money creates. Clearly, low rates were what created this mess last decade; why should we believe that more of the same will bring redemption in this decade.

In terms of the political economy the Fed is constrained. Three months ago, when the calls for more QE began I wrote:

each time the Fed has conducted one of these campaigns of non-traditional stimulus, there has been a vocal political opposition to it. So, the Fed feels constrained. They will expand their balance sheet only if things really look terrible. Otherwise they will look for other forms of non-traditional policy. We saw this in August when the Fed telegraphed its intention to keep rates at zero for two years. They subsequently increased this stance to three years. My view is that the Fed will continue to target long rates or move into adjacent markets like mortgage-backed securities before it engages in any outright QE.

Does QE even work? The answer is no. Every time the Fed has done QE, rates have increased, not decreased.

Other arrows in the Fed’s quiver include Operation Twist and rate easing aka permanent zero. I see rate easing as more effective at lowering rates than Operation Twist since the Fed operates by controlling price/yields and not quantity. Operation Twist is a quantity operation that can fail just like QE while rate easing operates by changing future interest rate expectations. But again I have to caution that lowering rates is a double edged sword where the balance has become negative both in terms of savers’ and banks’ net interest. I think these policies are toxic.

The most that can be said here is that the Fed wanted to do something because they wanted to show markets that at least the Fed is on the case, that the US economy is receiving policy support. But this kind of signalling effect only goes so far. It has zero impact on the real economy and I believe it will fail.

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