Why QE will fail, dissonant voices edition

Note: this post has been changed to state that my analysis assumes that negative real rates are indicative of a loose monetary policy.

When it comes to the efficacy of Fed policy, there are a number of people you have to read. I like Stephen Roach for one. His column on the Fed’s Macro Malpractice was right on the money in my view. As controversial as his views are, I also like Marc Faber because he has been right on the money in saying that when economies turn down, central banks that can will always ‘print’. That is my view as well (though I disagree with Marc’s comments about hyperinflation). Then you have the MMT folks like Randall Wray, who told us QE2 was going to be a bust because it was just the equivalent of the Fed issuing treasury bills. He was right. These folks are telling you QE is bad for the economy and that QE will end in massive loan losses from inflated asset prices and distorted investment allocation. I agree and that’s  not even considering the loss of interest income which I believe only reinforces the hoarding kind of psychology of the balance sheet recession

But not everyone I listen to adheres to an anti-QE bias. There’s the FT’s Izabella Kaminska for one, with what I would describe as a novel twist on the concept of deadweight economic loss because of the artificial scarcity. Legitimately, Izzy’s artificial scarcity idea could include the artificial scarcity of money as Brodsky and Quaintance imply in their QE3 post from a few years back.  So while she has repeatedly warned about the negative unintended consequences of QE, her scarcity framework sheds light on why monetarists like Ambrose Evans-Pritchard support more liquidity (correct me if I’m wrong, but I believe Ambrose does support more liquidity in Europe). 

Just today, I came across a good article at the FT and another by Matt O’Brien on the potentially beneficial effects of the currency wars which had a positive spin on the effects of quantitative easing. Matt used an argument about the competitive currency devaluations of the 1930s that Great Depression expert Barry Eichengreen has made, the point being that ‘coordinated currency depreciations’ lead to positive outcomes. And while I don’t find that argument wholly convincing because of the spectre of economic nationalism that Bremmer and Roubini raised just today with their G-0 concept, today’s currency wars have not led to tariffs and trade wars yet.

Tim Duy has been very good in predicting Fed policy. He makes well-reasoned arguments on the cause and effect of this policy. I always like reading his material, even when his view is counter to mine. David Beckworth, along with Scott Sumner, is a leading proponent of nominal GDP targeting and the Fed’s ability to “catalyze the private sector into starting a robust recovery“. I don’t agree but his points are well-reasoned and represent some of the best ideas in favor of more Fed activism. 

What should the Fed do, especially in an environment of tighter fiscal policy?

As Tim Duy wrote me,

“What does the central bank do instead of what they are doing?  I have a hard time accepting that going backwards is going to work; the expectations shift will be disastrous, I think.”

Raising rates now would probably induce recession, yes. In the end, none of us has all the answers here as much as policy makers act as if they do. We are living through a crisis of historic proportions and the policies and programs being enacted are largely untested and unproven. The potential for error is extremely large.

For me, this means sticking to what I know and living with an uncomfortable ambiguity on all the rest. What I do know is that:

  1. modern central banks are price/rate targeting monopolists of the supply for base money reserves.
  2. as such, affecting rates/price via lowering or raising interest rates is the standard first-call policy tool of central banking today.
  3. the Fed and its European counterparts cannot lower interest rates any more without breaching the zero bound.
  4. therefore, central banks are trying to impact economies and financial systems via the quantity dimension.
  5. the Fed’s stated aims are to lower interest rates, reduce risk premia and alter portfolio preferences in order to bid up asset prices.
  6. Fed policy will have an unintended consequence in the loss of interest income and concomitant changes in investor behavior.

My assumption, therefore, is that quantity targeting, quantitative easing-type actions will have a more muted impact on the real economy than the actions of a price/rate targeting central bank, and that, as such, the central banks will fail to sustainably boost the real economy in the absence of fiscal policy expansion. Further, I believe that, to the degree central banks are effective, it will be in pumping up asset prices via lowered risk premia and the distortion of private portfolio preferences toward riskier and higher yielding assets and asset classes. In my view, this policy response is pure asset-targeting fetishism, a hallmark of our age that leads to excess private credit growth, resource misallocation and recurrent crises due to an increasingly fragile banking system and over levered private sector balance sheets. It will fail and this will be especially destructive to investors geared excessively to risk-on types of portfolios.

But, these are my conclusions based on my analysis of how the financial system operates and how monetary policy is transmitted, which differs from the mainstream . I am open to other interpretations and I expect the next US recession to be especially helpful in demonstrating whether my interpretation holds up. In the meantime, I will keep an open mind.

Where could I be wrong?

  1. in assuming that the real economy impact of QE is more muted than the impact of traditional policy. (So far, I have been right, however.)
  2. in assuming that tighter short-term fiscal policy will negate any short-term real economy effects of loose monetary policy
  3. in assuming that private sector balance sheets cannot be further levered
  4. in assuming that negative real yields are prima facie evidence of easy money when others like Scott Sumner believe monetary policy has been too tight

Just like we saw in 2000 and 2001 after the tech bubble, low to negative real rates can reflate effectively. But I still ask to what effect? Sure I could be wrong about how effective QE will be from a cyclical perspective. But what happens when this business cycle ends and rates are still zero?

In any event, my role here is not to question policy, thinking I might have some influence over it. I accept policy for what it is and would rather predict how it will progress and what impact these policies will have on asset markets and the economy. I believe easy money is here to stay. If anything, it will get easier. At least in the US, the Fed has explicitly told us this, with Ben Bernanke saying he and his colleagues “expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens.” That has to be bullish for risk assets – unless the US economy double dips due to the fiscal cliff. The question then is which assets will benefit most and least and whether by that time “accommodative monetary policy could provide tinder for a buildup of leverage”. The Fed is hoping easy money has not and that it will not provide tinder for leverage… and another bust before it has the opportunity to normalise policy. I believe it already has and that this will be extremely problematic in the next recession.

Feel free to rebut.

  1. David_Lazarus says

    You are right that in that the Fed may not be able to normalise rates before the next recession. If some are right and that we will enter a recession in the new year then what scope does the Fed have? It will then become bearish for assets even though the Fed has pledged indefinite support for them. Unless there is real demand for goods and services then asset prices will look even more over valued. So while many are talking about a floor for home prices I think the prospects are dim. They may stagnate for a while until the next recession where they fall again, but when they stabilise again it will be at new lows and stagnate there till the next recession. This is typical of sticky prices and will sap confidence. Assets are still over valued and there will be another crisis before long because the Fed are inflating bubbles everywhere but do not realise where they are yet.

  2. Dave Holden says

    I agree with everything here. Fundamentally it seems to me that QE in its various forms is really only about preserving a price structure that was distorted by misallocation of credit – i.e., avoiding writedowns. The word preserving is key, if I thought it had a chance of rectifying this distortion I would be more supportive, but I just don’t understand how this will happen.

    Really QE needs to be combined with a proactive fiscal policy, a realistic but sensitive assessment of banks balance sheets and an aggressive rooting out of fraud.

    Once that is done, a review needs to be made on bank’s risk weighting of their assets and their general approach to credit creation.

    1. Edward Harrison says

      The interesting thing is what a hedge fund friend recently reminded me about the fiscal side of this debate. He wrote that corporate profitability is the flip side of the deficit, and will get crushed if there’s any serious attempt to rein in government spending. That is a very astute read and one we should all heed as investors. At the first sign of deficit cutting actually happening, we should be thinking of which sectors will get hurt most and whether selling those shares is the right thing to do.

      1. David_Lazarus says

        Well finally an investor who understands national accounting. The next big opportunity to find out what sectors will gain or lose comes at the general election. A strongly conservative congress will probably favour cuts which will hit some sectors more than others. Apparently Walmart gets as much as 40% of its sales in some stores from Food Stamps so could be a major sell if Romney gets elected.

  3. Shaun Richards says

    Hi Edward
    Thanks for an interesting and thoughtful article. I share many of your doubts about central banks and QE and have been a long time proponent of the they have no “exit strategy” view. But as I have discussed today in an article on Japan’s experience I think that central banks forgot this from the San Francisco Federal Reserve in 2006 which was discussing Japan’s original experiment in this area.
    “Moreover, in strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform.”
    We are very likely to be in an even weaker state when the next recession strikes than we were before the last one…..

    1. Edward Harrison says

      Agree. This was the lesson from the Japanese recession of 1997 and the results were disastrous to say the least.

      See here for my take on this:


  4. bc says

    Why do I feel like I’m sitting in a theater full of people thinking, “This place is a fire trap. At the first whiff of smoke I’m bugging out of here.” All I can say is, there better not be even a tiny whiff of smoke (in the markets), cause the herd is primed for a stampeed.

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