By Stephen Jen, SLJ Macro Partners LLP.
Bottom line: In the four years since the Great Recession, investors have been conditioned to look to the Fed for assistance whenever there is an episode of risk-off. Indeed, quantitative easing (QE), by artificially depressing the long-term interest rates, was designed to work through the ‘portfolio balance’ channel, whereby investors are discouraged to hold cash or bonds and are incentivized to hold risky and high yielding assets. Through the paper wealth effect and a general sense of prosperity, it is hoped that QE could jump start the economy. In our opinion, the benefits of QE are temporary and the magnitude of the impact may be diminishing, while the costs are significant and have been accumulating. Investors presumably understand the benefits (e.g., positive for equity prices, and the low interest rates should be helpful for both indebted households as well as the government). The list of potential costs is long. The main ones include (1) persistent QE raises inflation risk over the medium term, (2) QE in the US has important negative side effects on other countries, (3) QE could lead to moral hazard problems such as delayed structural/fiscal reforms, and (4) QE could significantly elevate financial volatility.
In this note, we summarize the benefits and the costs of QE. We believe the potential benefits tend to be short term in nature, while there could be potential costs over the medium term. Further, as central banks persist with QE, over time, the marginal benefits could abate, while the marginal costs rise, we suspect. At some point, the benefit-cost balance flips. We suspect the US may be approaching such a point. If we are correct in our analysis, open-ended QE by the Fed could sow the seeds for serious problems in the future, not just in the US but also outside the US, especially in some EM economies.
Some introductory words about ‘QE.’ ‘QE’ is a generic term that includes different types of unconventional monetary policies, i.e., monetary operations that involve the altering of the central banks’ balance sheets when the cash interest rates are already close to zero. However, the unconventional monetary operations conducted by the various central banks since the Great Recession are quite distinct from each other, even though all of them are generally referred to as ‘QE.’ Our friend Mr. Tetsuya Inuoe suggested a useful framework for thinking about these different types of QE. The chart below shows four categories of QE, delineated by (i) whether the monetary objective is ‘conventional’ (i.e., aimed to deal with inflation), or ‘unconventional’ (aimed to deal with non-inflation related issues), and (ii) whether the tools are ‘conventional’ (through the buying of sovereign bonds) or ‘unconventional’ (through the buying of risk assets or currencies).
In the top-right quadrant, we have the conventional-conventional QE. After lowering the cash (policy) rate to zero, central banks are forced to convey easier monetary conditions by attempting to lower the longer term interest rates through sovereign bond purchases. As central banks buy up large chunks of sovereign bonds, the yield curve flattens, and, as the argument goes, the lower interest rate profile should be beneficial for the economy. The Bank of Japan was the first of the G7 central banks to conduct large-scale QE operations in 2001-06. The Fed’s QE2 and the BOE’s operations were also of this type.
In the bottom left quadrant, we have summarized the examples of central banks that have used unconventional tools to achieve unconventional objectives. For example, the SNB did not buy domestic bonds to generate inflation. Instead, they intervened heavily in the currency markets (and in turn bought foreign bonds) to depress the value of the CHF. The Fed’s own QE1 operation wasn’t even called QE, but ‘CE’, i.e., credit easing. This was because the aim was to support some risk assets and to diffuse imminent risk of a liquidity crisis. Similarly, the ECB’s LTRO operations did not involve direct purchases of sovereign bonds, and the aim was not to generate higher inflation.
In the bottom right quadrant, we show that the Fed’s Operation Twist used unconventional tools (simultaneously buying and selling fixed income instruments) to achieve a conventional objective – inflation.
Much of our discussion below pertains to observations about QE in general. The point of this section, however, is to point out the distinct differences between different QE operations, which we will examine in more detail in a different note.
Much larger central bank balance sheets. The balance sheets of the central banks conducting QE have expanded significantly. From around 10% of GDP, which would be considered ‘normal’, the balance sheets of the Fed, the ECB, and the BOJ have expanded to 22%, 27%, and 29% of GDP, respectively. The BoE’s balance sheet is now around 50% of the UK’s GDP, while the SNB’s balance sheet has breached 70% of Switzerland’s GDP.
Benefits and costs of QE. Fed officials – both doves and hawks – have reminded the market that there are tradeoffs with QE operations, though the doves tend to emphasize the benefits and ignore the costs, while the hawks tend to dismiss the benefits and fixate on the costs. As far as we are aware, no Fed official or Fed research has summarized the benefits and costs of their operations.
Benefit 1. Temporarily higher equity prices and confidence. Keynesian stimulus, whether fiscal or monetary, could in theory shift demand inter-temporally (i.e., bring future demand forward in time), but it cannot generate permanent increases in output. An economy’s potential growth capacity determines its ultimate economic growth path. Artificially reducing long-term real interest rates below zero would discourage savings and encourage borrowing to fund consumption or investment today that would have taken place tomorrow. This process is somewhat analogous to jump-starting a car that, after the initial jolt, is ultimately expected to run on its own power. We won’t show charts that most investors have already seen and understood, showing how after the announcement of each round of QE (QE1, QE2, and Operation Twist), equity prices rose not just in the US but also around the world. However, between each round of QE (between the end of QE1 and the beginning of QE2, and between QE2 and OT), equity prices sagged. This suggests that a good portion of the rally in equities has been due to monetary liquidity rather than the economic fundamentals. Proponents of QE might argue the counter-factual, that the economy would have been a lot weaker had it not been for the QE operations. Nevertheless, it is a fact that the linkages between QE and the real economy (‘Main Street’) are weak, while those between QE and the financial markets (‘Wall Street’) have so far been tight.
Benefit 2. A lower US dollar. QE by the Fed has also had a systematic relationship with the dollar: money-printing by the Fed = weaker dollar. A weaker dollar is seen by some as a positive for the US. We have written about how the Fed’s QE has severely distorted the relationship between the dollar and other key asset prices in the world. The charts below summarize how the normal relationships between some assets relative to economic growth (the panel on the left, with gold and bonds having a negative historical relationship with growth, while equities and oil showing a positive relationship with growth) have been distorted by the Fed (the panel on the right, with virtually all assets, except the dollar, showing a positive relationship with growth).
Cost 1. QE could lead to inflation in the future. We won’t go into the debate on whether or not the Fed is credible when the officials (like Chairman Bernanke) stress their determination to prevent a flare-up in inflation, because we believe that the Fed has both the willingness and most likely the ability to sharply tighten monetary conditions. Rather, our worry is that the Fed is likely to make a bad judgment call on when they should start tightening. The doves at the Fed tend not only to be the ones who are bearish on economic growth, but they also tend to hold the view that it is insufficient aggregate demand, rather than problems with the aggregate supply, that has been holding down US economic growth. Doves like Vice Chairperson Janet Yellen and the SF Fed President Williams argue that the US NAIRU (the equilibrium unemployment rate) has only risen slightly, from the level of 4.5%- 5.0% prior to the Great Recession, to around 5.5% now.3 At the same time, hawks tend to believe that the US economic malaise reflects, to a large extent, the country’s structural inability to compete in this ever-changing globalized world. They tend to believe that the financial crisis has exposed these supply-side weaknesses of the US and that the true equilibrium unemployment rate is nowhere close to the pre-crisis levels, which were flattered by the credit and the housing bubbles. Specifically, there have been suggestions that the new equilibrium unemployment rate could be closer to 7% than 5%. If the doves are right, then the Fed should only start to tighten its stance when the unemployment rate falls below 7%. However, if the hawks are right, the Fed will need to have completed their tightening by the time the unemployment rate reaches 7%. With so much monetary liquidity generated by QE, the scope for a major policy error on inflation control is quite material, in our opinion.
Cost 2. QE exports unwelcomed liquidity to EM. The Fed’s QE is meant to encourage risk-taking, not just in the US (from bonds to equities), but also outside the US (into higher-yielding EM markets). With all of the top five issuers of reserve currencies (USD, EUR, JPY, GBP, and CHF) conducting QE, capital has been repelled from DM into EM. While, prior to 2008, the capital flows into EM may have been pulled in by the superior economic fundamentals of EM, post-2008, however, much of the capital flows into EM have been pushed by DM. Until the Great Recession, DM’s credit cycle had lasted eight years, but EM’s credit cycle has lasted 12 years, with the last bit helped by DM economies’ QE. The maturity of EM’s credit cycles has made policy makers in EM much more concerned about the imbalances in their own economies. China, for example, has begun to proactively cool down its economy through the housing markets. Similarly, Brazil has also initiated policies that are unfriendly to short-term capital inflows. The term ‘currency war’, coined by the Brazilian Finance Minister Mantega in 2010, applies not only to the currency values but also refers to the distortionary effects on the credit cycles of the recipient countries. The USDBRL being pushed by Brazil from 1.70 to 2.00 should thus be seen as Brazil’s new currency policy as much as its credit policy.
Cost 3. QE could lead to serious problems of moral hazard for the governments. Aggressive QE could dis-incentivize governments from conducting politically difficult structural and fiscal reforms. QE helps ease economic and financial pains temporarily but should be understood as time bought for the governments to take actions on reforms. With central banks being the largest buyer of sovereign bonds in many DM economies, the costs of borrowing are artificially held low, reducing the urgency for the government to do the right things. The US is a perfect example. The debt ceiling debate last year helped focus, momentarily, the debt discussion on Capitol Hill. But instead of making further progress in dealing with the US’ fiscal challenges (e.g., coming up with proposals about corporate tax reform or entitlement reform), the US Congress has made almost no progress since its long-term sovereign debt rating was downgraded by the S&P on August 5, 2011. QE2 and Operation Twist by the Fed have, in turn, helped keep the cost of borrowing low for the US government. The automatic fiscal cuts scheduled to take place in early 2013 are now described as a ‘fiscal cliff’, which most assume Congress will again postpone, rather than confront. Our view is that the Fed is guilty of encouraging inaction by the Government. The same could be said about structural reforms in the US, which have been lagging the progress in Europe.
Cost 4. QE could significantly elevate financial volatility. One of the key benefits of QE is higher equity prices, as mentioned above. However, without economic growth, buoyant equity prices are likely to be temporary, to be followed by sharp sell-offs. The chart below shows the performance of the Nikkei, which, after the end of QE in Japan, promptly lost more than half of its value. Further, the uncertainty regarding when different central banks might terminate their QE operations will create a considerable amount of financial volatility.
Main Street versus Wall Street. With risk assets weakening in recent days, there will invariably be calls for the Fed to step up with more QE. This market psychology reflects not only investor addiction to QE, but also the vastly different effects QE has had on ‘Wall Street’ (i.e., the financial sector) and ‘Main Street’ (the real economy). Since the Great Recession in 2008, the Fed’s monetary operations absorbed part of the economic and financial risk into its own balance sheet, in the hope of supporting employment and general economic growth. However, much of the short-term benefits have gone to the financial markets and not the real economy, as the Fed’s and other central banks’ monetary transmission mechanisms remain clogged. Further QE would probably boost asset prices temporarily, without having a material impact on the real economy.
Bottom line. QE has both benefits and costs. The doves at the Fed seem to be rather ignorant of the mounting negative side effects, in our view. Inflation in the US, Euroland and the UK has remained higher than is consistent with the output gaps. Continued QE could undermine the credibility of these central banks with regard to inflation control. Further, QE has negative side effects on EM and could create moral hazard problems for urgently-needed structural and fiscal reforms. Finally, since QE may only boost asset prices temporarily, over time, without a material shift in the trajectory of the economy in question, QE would only increase financial volatility, with no lasting positive effects on asset prices. Weighing the benefits and the costs of QE, the hurdles for the Fed to justify QE3 seem high.
Stephen Jen is the managing partner at SLJ Macro Partners.
Prior to establishing SLJ Macro Partners in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition, Stephen was actively involved in the design of the IMF’s framework for providing debt relief to highly indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Monetary Economics. He also earned a BSc in Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born in Taipei, Taiwan, and now lives in London with his wife and two children.