Can central banks kick the QE habit?

Janet Yellen and Mario Draghi © Getty Images
Yellen and Draghi side-stepped any discussion of QE at Jackson Hole

Stimulating the economy through quantitative easing may have averted a slump after the financial crisis – but breaking our addiction to it could spook markets, says Simon Wilson.

How does QE work?

In the case of the UK, quantitative easing (QE) involves the Bank of England buying gilts (UK government bonds – see box for more). This pushes up the price, and pushes down the yield – the interest rate on the bond (yields fall as prices rise and vice versa). This encourages investors to buy riskier assets with higher yields instead, such as corporate bonds and shares (this is sometimes known as the “hot potato” effect). Thus the effect of QE is ultimately the same as monetary easing by the conventional means of cutting the base interest rate. As the prices of corporate bonds and shares are driven higher, funding costs for businesses fall, encouraging them to spend and invest more. Rising asset prices create a “wealth effect”, encouraging consumer spending – and help strengthen banks’ balance sheets, enabling them to lend more.

Has it worked in practice?

Economists will be debating that question for decades. QE probably helped to prevent a deep slump in the aftermath of the financial crisis. However, it may have been less significant than the recapitalisation of banks by governments, and the deep, co-ordinated cuts to interest rates made by central banks. One common criticism of QE, articulated recently by Larry Elliott in The Guardian, is that much of the extra money swilling around the economy has gone into asset prices, rather than into tackling the structural weaknesses that underlie low growth. “Rich people benefited because the value of their homes and share portfolios went up; poor people suffered because commodity prices also went up, raising food and fuel prices,” says Elliott. The other big problem with QE – according to Nicholas Macpherson, who served as permanent secretary to HM Treasury from 2005 to 2016 – is that it is “like heroin”.

What does he mean?

Macpherson, who was the civil servant in charge of the Treasury when QE was introduced, is clearly no longer a fan (if he ever was). “QE like heroin: need ever increasing fixes to create a high. Meanwhile, negative side effects increase,” he wrote on Twitter a fortnight ago. “Time to move on.” His tweet was in response to a warning by Rupert Harrison, George Osborne’s former chief of staff, that the European Central Bank (ECB) risked a “slow motion car crash” if it abandoned QE too quickly. The exchange reflects the intensifying debate over how to manage the great unwinding of QE. Macpherson’s implied point, of course, is that it is hard simply to “move on” from heroin – and it may be similarly difficult to break the QE addiction and “normalise” monetary policy.

Hasn’t this already started?

Sort of. The US Federal Reserve began phasing out its asset-purchase programme and edging up rates in 2015. The ECB is now debating how fast to taper its own QE policy, and when to start phasing out negative interest rates. And the Bank of England has just finished its latest round of post-Brexit-referendum QE. Soon enough, the Bank of Japan and the Swiss National Bank will be the only central banks maintaining unconventional monetary policies, reckons economist Nouriel Roubini. So tightening has begun – but the question of how it will play out is worrying investors. Before last weekend’s central bankers’ jamboree at Jackson Hole in Wyoming, there was much speculation about what kind of steer the Fed’s Janet Yellen and the ECB’s Mario Draghi would give markets. In the event, they both avoided discussing monetary policy, instead focusing on regulation and free trade respectively.

Why will unwinding QE be so tricky?

Economic growth remains tentative; global debt is far higher than it was before the financial crisis in 2007; and valuations in bond, equity and property markets are either at unprecedented levels or very expensive by historic standards. So one big concern is how dependent these assets are on QE to keep their values propped up – one reason for Draghi and Yellen’s reluctance to discuss their next moves at Jackson Hole is to avoid potential skittishness in the markets for as long as possible. Some economists, including Roubini, note that even if normalisation proceeds successfully, interest rates are unlikely to return to the 5.25% high seen at the end of the previous tightening cycle in 2007. Instead, with both growth and inflation weak, the peak for this cycle is likely to be no higher than 3%.

What might the consequences be?

The fear is that because rates are so low, the Fed will not have enough room for manoeuvre when cutting rates when the next recession strikes. “Interest-rate cuts will run into the zero lower bound [and stop working to stimulate growth] before they can have a meaningful impact on the economy,” Roubini wrote recently. At that point, central banks will have to confront the same policy dilemmas as during the crisis, and QE is almost certain to be part of their solution. “Given that financial push is bound to come to economic shove once again, unconventional monetary policies, it would seem, are here to stay.”

Quantitative easing: what is it?

Quantitative easing is an “unconventional” form of monetary policy in which a central bank creates new money electronically and uses it to buy financial assets – normally government bonds – from big institutional investors. The idea is that when short-term interest rates are near zero, QE can stimulate the economy by helping to cut interest rates across the board, and eventually drive inflation back up to target levels (2% in the UK). In the UK, the Bank of England started by pumping £200bn into the gilt market in 2009 in the wake of the financial crisis. This grew over the years to £435bn, including an extra £60bn immediately after the Brexit vote in June 2016. In the US, the Federal Reserve bought about $4.5trn (£3.5trn) of assets. The European Central Bank and the Bank of Japan also run huge QE programmes.