The Filter^: The emerging view on QE2

Further to my article on QE2, I've read some good articles on the subject.

Raghu Rajana offers a measured overview:

Clearly, the Fed’s objective is to increase bond prices, in the hope that lower long-term interest rates will propel corporate investment. In addition, the Fed hopes that lower long-term interest rates will push up asset prices, giving households more wealth and greater incentive to spend. Finally, by demonstrating a willingness to print money, the Fed hopes to increase inflationary expectations from their current low levels.

In the FT Martin Fieldstein provides a nice intro:

Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices.

Mr Bernanke’s argument for QE is based on the “portfolio balance” theory which stresses that, when the Fed buys bonds, investors increase their demand for other assets, particularly equities, raising their price and increasing household wealth and spending.

He goes on to list several downside risks:

Like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels
The lower US interest rates are causing a substantial capital flow to those economies, creating currency volatility. The economies hurt by the increasing value of their currencies are responding with measures to protect their exports and limit their imports, measures that could lead to trade conflict
the increased cash on banks’ balance sheets will make the Fed’s exit strategy harder

Even better, writing in Prospect, Faisal Islam writes a fantastic essay trying to assess the impact of QE1. I'll provide some commentary. Firstly, I wasn't the only person paying attention to Willem Buiter - in short ideas matter:

David Cameron’s response was more measured. I met him at that time and he seemed to have recently mugged up on advanced monetary economics. He referenced economist Willem Buiter’s blog in depth and regaled me with his knowledge of the difference between quantitative easing (the sheer amount of buying the central bank could do) and qualitative easing (an attempt to lower interest rates in specific markets, such as mortgage debt and corporate credit).

Islam provides a nice account of the actual provess by which QE operates:

On any given morning the debt management office (DMO), an arm of the treasury, sold billions of pounds worth of British gilts to the world. Then in the afternoon, barely 400 metres away, the Bank held a reverse auction where it, in effect, bought up billions of similar government debts. Under EU rules it would have been illegal for the DMO and the Bank to trade with one another. So instead the City stepped in, making profits on trading both sides of this bizarre monetary merry-go-round for over a year.

As I said on the day after it launched,

Although we are not monetising the government debt in the same way that Zimbabwe has, it is hard to make any clear distinction. Yes, the Bank of England is purchasing assets on the secondary market (not directly from the Treasury). Yes, the Bank has every intention to mop up this additional liquidity once the economy recovers, but "directness" and "intentions" are largely semantic.

The head of the DMO does little to deny this:

“On the other hand, we must make the distinction—we are raising money by selling new gilts but the Bank is buying old gilts in the secondary market.”

In my assesment of QE1 I tried to identify the winners,

banks have benefited. QE served as a bailout by the back door

Islam adds more detail:

"It’s not to say that what the Bank [of England] is doing is useless—it has helped the banks, but it doesn’t inject new money. That is only injected when the money leaves the banking sector and goes into the economy. So far the money has just been passed from central banks to commercial banks,”

Indeed:

Winners from QE include the City trading desks that saw the value of their bond portfolios soar. Other beneficiaries include the sovereign bond dealers who passed bonds from the DMO to the Bank at almost no risk, and the commercial banks who gained a supportive source of free funding.

The losers, on the other hand:

director general of Saga, Ros Altmann, says: “QE is the worst thing that could happen to pensions, it is devaluing and destroying pensioners’ income.”

Islam interviews Alistair Darling for the article, and although you'd have thought Darling might have made this point before authorising £200bn of spending, he says (remarkably candidly):

We need a treasury and Bank of England evaluation as to where it is. Is it in circulation, or sitting in bank vaults?”

Audit the Bank? Here here.

The article also gives a lot of attention to the notion of NGDP targetting

“The Bank needs to set a nominal GDP growth target,” he [Richard Werner] says. A nominal GDP target incorporates a bit of inflation and a bit of growth in one target

Wener is the economist who coined "quantitative easing" to argue that Japanese policy was not radical. A further argument that Austrian's might be interested in, is the distinction between an expansion in the money supply to offset an increase in the demand for money, and an expansion in the money supply as a means to stimulate aggregage demand. According to Simon Ward:

“QE1 wasn’t inflationary, it was antideflationary, but QE2 would be very dangerous, because there is no shortage of liquidity and the banking system is stronger.”

Finally, as I keep trying to point out we are yet to solve the underlying problems that caused the crisis - and if we learn one lesson from Japan it should be that zombie banks are not conducive to monetary nor fiscal stimuli. Danny Gabay's thoughts on this are interesting:

He contends the failure to cleanse Japan’s bank balance sheets of zombie property companies (insolvent companies kept afloat by the banks) caused its lost decade. Zombie households with large debts and overvalued property is the British equivalent. QE could be used to buy up houses at a discount, jump-starting a stalled property market.

I'd argue that house prices need to drop, and policy should be directed towards how this might happen without consigning millinos to a lifetime of debt, but the bottom line needs to be bank restructuring. I don't think we can see a recovery until some banks go bankrupt.

5 Comments

"Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices."

If we have had real losses in the recession, and I think we undoubtedly have, then the long-run natural rate of interest is unlikely to be a low as it was at the beginning of the crisis. With that it mind we should be worried if bond prices rise beyond where they were before the crisis. Then we're very likely to be in the territory of setting up for the next bubble.

Posted by: Current | November 09, 2010 at 07:16 PM

aje,

Are you reading the Bank's own literature on QE? Islam is incorrect on several important aspects of the programme and thus ends up drawing conclusions unsupported by the facts.

Firstly, by design the Bank was not buying bonds from banks. It was buying gilts from non-banks, and doing so in order to force them to hold more corporate bonds and paper, in order to reduce the cost of corporate debt and equity issuance. (Other effects: rates on long term govt debt and inter-bank rates were brought down).

The Bank is aware of the potential problem of investors buying gilts from the DMO and taking them straight to the APF for an easy spread. It deliberately targeted a purchase rate in excess of new issuance by DMO (3x faster); it used competitive reverse auctions to obtain clearing prices close to market; and it didn't include in the operations any gilts about to be issued or recently issued by the DMO.

The characterisation of QE as a loop between the BoE and the DMO closed by the banks is thus false, as far as I can see.

The APF's operations did indeed inject new money into the economy, since the fund was purchasing gilts held by non-banks, not by banks. The direct consequence of the BoE asset purchase programme was increased deposit balances held by the non-bank private sector (plus reserves excess to demand in the banking system). Where did this money go? Different (v. interesting!) question.

Also:

What part of this statement makes sense? Please explain.

Posted by: vimothy | November 10, 2010 at 02:00 PM