The US Federal Reserve, like many other central banks, engaged in massive quantitative easing in the wake of the financial crisis of 2007/8. Over three rounds, QE1, QE2 and QE3, it accumulated $4.5 trillion of assets – mainly government bonds and mortgage-backed securities (see chart below: click here for a PowerPoint). But, unlike its counterparts in the UK, the eurozone and Japan, it has long ceased its programme of asset purchases.. In October 2014, it announced that QE was at an end. All that would be done in future would be to replace existing holdings of assets as they matured, keeping total holdings roughly constant.
But now this policy is set to change. The Fed is about to embark on a programme of ‘quantitative tightening’, already being dubbed ‘QT’. This involves the Fed reducing its holdings of assets, mainly government bonds and government-backed mortgage-related securities.
This, however, for the time being will not include selling its holding of bonds or mortgage-backed securities. Rather, it will simply mean not buying new assets to replace ones when they mature, or only replacing part of the them. This was discussed by the 75 participants at the joint meeting of the Federal Open Market Committee (FOMC) and Board of Governors on 14–15 March.
As the minutes put it: “Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”
A more active form of QT would involve selling assets before maturity and thus reducing the size of the Fed’s balance sheet more rapidly. But either way, reducing assets would put downward pressure on the money supply and support the higher interest rates planned by the FOMC.
The question is whether there is enough liquidity elsewhere in the system and enough demand for credit, and willingness of the banking system to supply credit, to allow a sufficient growth in broad money – sufficient, that is, to support continued growth in the economy. The answer to that question depends on confidence. The Fed, not surprisingly, is keen not to damage confidence and hence prefers a gradualist approach to reducing its holdings of assets bought during the various rounds of quantitative easing.
Fed’s asset shift to pose new test of economy’s recovery, resilience Reuters, Howard Schneider and Richard Leong (6/4/17)
Federal Reserve likely to begin cutting back $4.5 trillion balance sheet this year Washington Post, Ana Swanson (5/4/17)
Why the Fed’s debate about shrinking its balance sheet really, really matters Money Observer, Russ Mould (7/4/17)
The Fed and ECB keep a cautious eye on the exit Financial Times (7/4/17)
Get ready for the Fed’s next scary policy change CBS Money Watch, Anthony Mirhaydari (5/4/17)
The Fed wants to start shrinking its $4.5 trillion balance sheet later this year Business Insider, Akin Oyedele (5/4/17)
Inside the Fed’s March Meeting: The Annotated Minutes Bloomberg, Luke Kawa, Matthew Boesler and Alex Harris (5/4/17)
QE was great for asset prices – will ‘QT’ smash them? The Financial Review (Australia), Patrick Commins (7/4/17)
Shrinking the Fed’s balance sheet Brookings, Ben Bernanke (26/1/17)
Selected data Board of Governors of the Federal Reserve System
- Distinguish between active and passive QT.
- If QE is a form of expansionary monetary policy, is QT a form of contractionary monetary policy?
- Could QT take place alongside an expansion of broad money?
- What dangers lie in the Fed scaling back its holdings of government (Treasury) bonds and mortgage-backed securities?
- Why is it unlikely that the Fed will reduce its holdings of securities to pre-crisis levels?
- Why are the Bank of England, the ECB and the Bank of Japan still pursuing a policy of QE?
- What are the implications for exchange rates of QT in the USA and QE elsewhere?
- Find out data for the monetary base, for narrow money (M1) and broader money (M2) in the USA. Are narrow and/or broad money correlated with Federal Reserve asset holdings?
Interest rates have been at record lows across the developed world since 2009. Interest rates were reduced to such levels in order to stimulate recovery from the financial crisis of 2007–8 and the resulting recession. The low interest rates were accompanied by extraordinary increases in money supply under various rounds of quantitative easing in the USA, UK, Japan and eventually the eurozone. But have such policies done harm?
This is the contention of Brian Sturgess in a new paper, published by the Centre for Policy Studies. He maintains that the policy has had a number of adverse effects:
||There will be nothing left in the monetary policy armoury when the next downturn occurs other than even more QE, which will compound the following problems.
||It has had little effect in stimulating aggregate demand and economic growth. Instead the extra money has been used to repair balance sheets and support unprofitable businesses.
||It has inflated asset prices, especially shares and property, which has encouraged funds to flow to the secondary market rather than to funding new investment.
||The inflation of asset prices has benefited the already wealthy.
||By keeping interest rates down to virtually zero on savings accounts, it has punished small savers.
||By rewarding the rich and penalising small savers, it has contributed to greater inequality.
||By keeping interest rates down to borrowers, it has encouraged households to take on excessive amounts of debt, which will be hard to service if interest rates rise.
||It has lowered the price of risk, thereby encouraging more risky types of investment and the general misallocation of capital.
Sturgess argues that it is time to end the policy of low interest rates. Currently, in all the major developed economies, central bank rates are below the rate of inflation, making the real central bank interest rates negative.
He welcomes the two small increases by the Federal Reserve, but this should be followed by further rises, not just by the Fed, but by other central banks too. As Sturgess states in the paper (p.12):
In place of ever more extreme descents into the unknown, central banks should quickly renormalise monetary policy. That would involve ending QE and allowing interest rates to rise steadily so that interest rates can carry out their proper functions. Failure to do so will leave the global financial system vulnerable to potential shocks such as the failure of the euro, or the fiscal stresses in the US resulting from the unfinanced spending plans announced by Donald Trump in his presidential campaign.
Although Sturgess argues that the initial programmes of low interest rates and QE were a useful response to the financial crisis, he argues that they should have only been used as a short-term measure. However, if they were, and if interest rates had gone up within a few months, many argue that the global economy would rapidly have sunk back into recession. This has certainly been the position of central banks. Sturgess disagrees.
Damaging low interest rates and QE must end now, think thank warns The Telegraph, Julia Bradshaw (23/1/17)
QE has driven pension deficits up, think-tank argues Money Marketing, Justin Cash (23/1/17)
Hold: The ECB keeps interest rates and QE purchases steady as Mario Draghi defends loose policy from hawkish critics City A.M., Jasper Jolly (19/1/17)
Preparing for the Post-QE World Bloomberg, Jean-Michel Paul (12/10/16)
Stop Depending on the Kindness of Strangers: Low interest rates and the Global Economy Centre for Policy Studies, Brian Sturgess (23/1/17)
- Find out what the various rounds of quantitative easing have been in the USA, the UK, Japan and the eurozone.
- What are the arguments in favour of quantitative easing as it has been practised?
- How might interest rates close to zero result in the misallocation of capital?
- Sturgess claims that the existence of ‘spillover’ effects has had damaging effects on many emerging economies. What are these spillover effects and what damage have they done to such economies?
- How do low interest rates affect interest rate spreads?
- Have pensioners gained or lost from QE? Explain how the answer may vary between different pensioners.
- What is meant by a ‘natural’ or ‘neutral’ rate of interest (see section 3.2 in the paper)? Why, according to Janet Yellen (currently Federal Reserve Chair, writing in 2005), is this somewhere between 3.5% and 5.5% (in nominal terms)?
- What are the arguments for and against using created money to finance programmes of government infrastructure investment?
- Would helicopter money be more effective than QE via asset purchases in achieving faster economic growth? (See the blog posts: A flawed model of monetary policy and New UK monetary policy measures – somewhat short of the kitchen sink.)
- When QE comes to an end in various countries, what are the arguments for absorbing rather than selling the assets purchased by central banks? (See the Bloomberg article.)
We’ve considered Keynesian economics and policy in several blogs. For example, a year ago in the post, What would Keynes say?, we looked at two articles arguing for Keynesian expansionary polices. More recently, in the blogs, End of the era of liquidity traps? and A risky dose of Keynesianism at the heart of Trumponomics, we looked at whether Donald Trump’s proposed policies are more Keynesian than his predecessor’s and at the opportunities and risks of such policies.
The article below, Larry Elliott updates the story by asking what Keynes would recommend today if he were alive. It also links to two other articles which add to the story.
Elliott asks his imaginary Keynes, for his analysis of the financial crisis of 2008 and of what has happened since. Keynes, he argues, would explain the crisis in terms of excessive borrowing, both private and public, and asset price bubbles. The bubbles then burst and people cut back on spending to claw down their debts.
Keynes, says Elliott, would approve of the initial response to the crisis: expansionary monetary policy (both lower interest rates and then quantitative easing) backed up by expansionary fiscal policy in 2009. But expansionary fiscal policies were short lived. Instead, austerity fiscal policies were adopted in an attempt to reduce public-sector deficits and, ultimately, public-sector debt. This slowed down the recovery and meant that much of the monetary expansion went into inflating the prices of assets, such as housing and shares, rather than in financing higher investment.
He also asks his imaginary Keynes what he’d recommend as the way forward today. Keynes outlines three alternatives to the current austerity policies, each involving expansionary fiscal policy:
||Trump’s policies of tax cuts combined with some increase in infrastructure spending. The problems with this are that there would be too little of the public infrastructure spending that the US economy needs and that the stimulus would be poorly focused.
||Government taking advantage of exceptionally low interest rates to borrow to invest in infrastructure. “Governments could do this without alarming the markets, Keynes says, if they followed his teachings and borrowed solely to invest.”
||Use money created through quantitative easing to finance public-sector investment in infrastructure and housing. “Building homes with QE makes sense; inflating house prices with QE does not.” (See the blogs, A flawed model of monetary policy and Global warning).
Increased government spending on infrastructure has been recommended by international organisations, such as the OECD and the IMF (see OECD goes public and The world economic outlook – as seen by the IMF). With the rise in populism and worries about low economic growth throughout much of the developed world, perhaps Keynesian fiscal policy will become more popular with governments.
Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)
- What are the main factors determining a country’s long-term rate of economic growth?
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all countries rather than being the only country to pursue such a policy?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- What determines the size of the multiplier effect of such policies?
- What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
The linked article below from The Economist looks at whether the election of Donald Trump, the effects of the Brexit vote and policies being pursued elsewhere in the world mark a new macroeconomic era. We may be about to witness rising inflation and the end of the era of tight fiscal policy and loose monetary policy. We might see a return of a more Keynesian approach to macreconomic policy.
According to the article, since the financial crisis of 2008, we have been witnessing economies stuck in a liquidity trap. In such cases, there is little scope for further reductions in interest rates. And increases in money supply, in the form of quantitative easing, tend to be held in idle balances, rather than being spent on goods and services. The idle balances take the form of increased bank reserves to rebuild their capital base and increased purchases of assets such as shares and property.
Even if people did believe that monetary policy would work to boost aggregate demand and result in higher inflation, then they would also believe that any such boost would be temporary as central banks would then have to tighten monetary policy to keep inflation within the target they had been set. This would limit spending increases, keeping the economy in the liquidity trap.
With a liquidity trap, fiscal policy is likely to be much more effective than monetary policy in boosting aggregate demand. However, its scope to pull an economy out of recession and create sustained higher growth depends on the extent to which governments, and markets, can tolerate higher budget deficits and growing debt. With governments seeking to claw down deficits and ultimately debt, this severely limits the potential for using fiscal policy.
With the election of Donald Trump, we might be entering a new era of fiscal policy. He has promised large-scale infrastructure spending and tax cuts. Although he has also promised to reduce the deficit, he is implying that this will only occur when the economy is growing more rapidly and hence tax revenues are increasing.
Is Donald Trump a Keynesian? Or are such promises merely part of campaigning – promises that will be watered down when he takes office in January? We shall have to wait and see whether we are about to enter a new era of macroeconomic policy – an era that has been increasingly advocated by international bodies, such as the IMF and the OECD (see the blog post, OECD goes public).
Slumponomics: Trump and the political economy of liquidity traps The Economist (10/11/16)
- Explain what is meant by ‘the liquidity trap’.
- Why is monetary policy relatively ineffective in a liquidity trap? Use a diagram to support your argument.
- Why is fiscal policy (in the absence of public-sector deficit targets) relatively effective in a liquidity trap? Again, use a diagram to support your argument.
- Examine how the Japanese government attempted to escape the liquidity trap? (Search this site for ‘Abenomics’.)
- In what ways may the depreciation of the pound since the Brexit vote help the UK to escape the liquidity trap?
- Could a different form of quantitative easing, known as ‘helicopter money’, whereby government or private spending is financed directly by new money, allow countries to escape the liquidity trap? (Search this site for ‘helicopter money’.)
- Why may a political upheaval be necessary for a country to escape the liquidity trap?
The Bank of England’s monetary policy is aimed at achieving an inflation rate of 2% CPI inflation ‘within a reasonable time period’, typically within 24 months. But speaking in Nottingham in one of the ‘Future Forum‘ events on 14 October, the Bank’s Governor, Mark Carney, said that the Bank would be willing to accept inflation above the target in order to protect growth in the economy.
“We’re willing to tolerate a bit of an overshoot in inflation over the course of the next few years in order to avoid rising unemployment, to cushion the blow and make sure the economy can adjust as well as possible.”
But why should the Bank be willing to relax its target – a target set by the government? In practice, a temporary rise above 2% can still be consistent with the target if inflation is predicted to return to 2% within ‘a reasonable time period’.
But if even if the forecast rate of inflation were above 2% in two years’ time, there would still be some logic in the Bank not tightening monetary policy – by raising Bank Rate or ending, or even reversing, quantitative easing. This would be the case when there was, or forecast to be, stagflation, whether actual or as a result of monetary policy.
The aim of an inflation target of 2% is to help create a growth in aggregate demand consistent with the economy operating with a zero output gap: i.e. with no excess or deficient demand. But when inflation is caused by rising costs, such as that caused by a depreciation in the exchange rate, inflation could still rise even though the output gap were negative.
A rise in interest rates in these circumstances could cause the negative output gap to widen. The economy could slip into stagflation: rising prices and falling output. Hopefully, if the exchange rate stopped falling, inflation would fall back once the effects of the lower exchange rate had fed through. But that might take longer than 24 months or a ‘reasonable period of time’.
So even if not raising interest rates in a situation of stagflation where the inflation rate is forecast to be above 2% in 24 months’ time is not in the ‘letter’ of the policy, it is within the ‘spirit’.
But what of exchange rates? Mark Carney also said that “Our job is not to target the exchange rate, our job is to target inflation. But that doesn’t mean we’re indifferent to the level of sterling. It does matter, ultimately, for inflation and over the course of two to three years out. So it matters to the conduct of monetary policy.”
But not tightening monetary policy if inflation is forecast to go above 2% could cause the exchange rate to fall further. It seems as if trying to arrest the fall in sterling and prevent a fall into recession are conflicting aims when the policy instrument for both is the rate of interest.
BoE’s Carney says not indifferent to sterling level, boosts pound Reuters, Andy Bruce and Peter Hobson (14/10/16)
Bank governor Mark Carney says inflation will rise BBC News, Kamal Ahmed (14/10/16)
Stagflation Risk May Mean Carney Has Little Love for Marmite Bloomberg, Simon Kennedy (14/10/16)
Bank can ‘let inflation go a bit’ to protect economy from Brexit, says Carney – but sterling will be a factor for interest rates This is Money, Adrian Lowery (14/10/16)
UK gilt yields soar on ‘hard Brexit’ and inflation fears Financial Times, Michael Mackenzie and Mehreen Khan (14/10/16)
Brexit latest: Life will ‘get difficult’ for the poor due to inflation says Mark Carney Independent, Ben Chu (14/10/16)
Prices to continue rising, warns Bank of England governor The Guardian, Katie Allen (14/10/16)
Bank of England
Monetary Policy Bank of England
Monetary Policy Framework Bank of England
How does monetary policy work? Bank of England
Future Forum 2016 Bank of England
- Explain the difference between cost-push and demand-pull inflation.
- If inflation rises as a result of rising costs, what can we say about the rate of increase in these costs? Is it likely that cost-push inflation would persist beyond the effects of a supply-side shock working through the economy?
- Can interest rates be used to control both inflation and the exchange rate? Explain why or why not.
- What is the possible role of fiscal policy in the current situation of a falling exchange rate and rising inflation?
- Why does the Bank of England target the rate of inflation in 24 months’ time and not the rate today? (After all, the Governor has to write a letter to the Chancellor explaining why inflation in any month is more than 1 percentage point above or below the target of 2%.)
- What is meant by a zero output gap? Is this the same as a situation of (a) full employment, (b) operating at full capacity? Explain.
- Why have UK gilt yields soared in the light of a possible ‘hard Brexit’, a falling exchange rate and rising inflation?