It would seem that the US quantitative easing policy has had a positive effect. New figures show US jobs creation has strengthened, while consumers’ confidence has hit a five year high, home prices have grown at the highest rate since 2006, and real GDP growth has accelerated to 2.4% in the first quarter of 2013.
The markets clearly do not want it to end: when Federal Reserve Chairman Ben Bernanke announced a possible tapering of the policy a couple of weeks ago, the Dow Jones industrial index dropped 625 points from 15284.82 points to 14659.56 points, with most major markets also following with losses.
So, why does the Federal Reserve want to end this bonanza - and risk further market volatility - by moving away from QE?
The short, perhaps brutal answer is that QE cannot last forever and QE does not fix the structural weaknesses of the economy. Similarly to drugs, it might make you feel well in the short-term, but it can give you serious problems in the long-term. And everybody would agree that you do not want to become addicted to drugs.
Show me the money
In a nutshell, QE is an extreme form of expansionary monetary policy. While standard monetary expansions occur through the purchase of short-term government bonds to reduce interest rates, QE involves purchasing large amounts of financial assets (including government bonds) from commercial banks and other private institutions to increase the monetary base.
The Fed has undertaken three waves of QE. The first one started in November 2008 and practically lasted until June 2010. The second one took place between November 2010 and June 2011. The third one was launched in September 2012 with the announcement that the Fed would buy $40 billion worth of financial assets a month. This amount was raised to $85 billion per month in December 2012. After Bernanke’s announcement last month, most economists expect that the Fed will start trimming its purchase of assets in September and end buying in June 2014.
The central banks of some other industrial economies have used QE in response to the crisis. For instance, in 2009, the Bank of England, having already reduced interest rates to 0.5%, decided to stimulate the economy with a purchase of £200 billion worth of financial assets. Further purchases occurred in October 2011 and February 2012.
Japan is a country that seems to rely on QE even more heavily than the US. Throughout 2011, the Bank of Japan purchased the equivalent of about $190 billion of financial assets. In April 2013, the bank announced an asset purchase program worth around $1.4 billion in two years to double money supply and accommodate the expansionary fiscal policy of the Shinzo Abe government.
Certainly, money was needed to address systemic risks in the aftermath of the financial crisis of 2007-2008 and to buffer the recession that followed. In the context of the current European debt crisis and the shaky economic outlook worldwide, increasing money supply can help strengthen market confidence and boost aggregate demand. In other words, QE might be good in the short-term. But the long-term is a different beast.
Cycle versus growth
The dynamics of the economy consists of short-term cyclical fluctuations around a long-term trend. Fluctuations are, by definition, not persistent and give raise to a continuous alternation of expansions and contractions, each lasting on average a few months. Particularly deep and prolonged contractions are identified as recessions.
Cyclical fluctuations are costly and ought to be stabilised. Monetary policy is one possible way to achieve this business cycle stabilisation: when the economy enters a downturn, then a monetary stimulus strengthens aggregate demand and facilitates the recovery. Conversely, in a boom, a monetary contraction prevents the economy from overheating.
This is why, in the face of a recession, a monetary expansion is desirable. When interest rates are already low, then this monetary expansion can be achieved through QE. Given the depth of the recessions of these last few years and the very low level of interest rates, it is therefore not surprising that some central banks have engaged in QE.
But as the money base keeps expanding, and the currency devaluing, inflationary pressures build up. In a cyclical contraction, a moderate increase in inflation is acceptable and even desirable. But once the contraction is passed, raising inflation can have distortionary effects on the functioning of markets, the distribution of income, and ultimately the long-term growth prospects of the country.
Several decades of economics research indicate that a constantly growing stock of money does not produce long-term growth. Long-term growth requires structural reforms, technological innovation, sound economic institutions, and a stable macroeconomic environment characterised by low and predictable inflation and a balanced public budget.
Therefore, monetary policy should be run counter-cyclically. In a time of cyclical downturn, monetary policy should be expansionary and inflation should be allowed to increase (moderately). In a time of cyclical boom, monetary policy should become restrictionary and lead to a decrease in inflation.
Such type of counter-cyclical pattern would ensure that monetary policy (a) contributes to the stabilisation of cyclical fluctuations while (b) keeping inflation low in the medium-long term.
If QE were protracted over the long-term, then monetary policy would no longer be counter-cyclical and inflation could be easily spin out of control, with adverse consequences on growth. In this regard, the strategy chosen by Japan is risky, to say the least, as it relies on a combination of very expansionary fiscal and monetary policies to stimulate long-term growth. This is not too different from what was tried in the 1990s, which became known as “Japan’s lost decade”.
The Fed’s decision to trim QE is instead consistent with a counter-cyclical approach to monetary policy. The available data and leading indicators suggest that the US economy is heading out of the cyclical contraction, hence the need to move to a less expansionary monetary policy stance.
Stock market’s cold turkey was inevitable, but it does not make the decision of the Fed wrong. In fact, one almost wishes that the “therapy” pursued by the Fed in the last few years could become a reference for central bankers in Frankfurt.