What do we actually know with some degree of certainty ("stylized facts") about QE, its effects on the markets and the economy? Well, for starters, the sheer size of it. Since 2007, the big four central banks (Fed, ECB, BoJ, BoE) have embarked on nearly $5 trillion of asset purchases [The Economist]. That's an altogether rather formidable sum.
How is it supposed to work?
By embarking on QE, central banks purchase assets (mostly government bonds which are deemed "safe" assets, at least of those governments issuing bonds in their own currency).
There are candidates, from a McKinsey report:
- Reducing "safe" interest rates has government borrowing cost
- Reducing "safe" interests rates shifts people to real assets like real estate and stocks, creating a wealth effect
- Reducing "safe" interest rates increased the value of bonds, creating a wealth effect
- Reducing "safe" interest rates has pushed business to increase investment (plant, machinery) by making the relative returns of these investments cheaper (lowering the 'hurdle' rate)
- Reducing "safe" interest rates reduces interest costs which lead to more business investing
- Reducing interest earnings has reduced household spending
The Economist noted this:
The consensus is that these actions have raised GDP by between 1% and 3% and prevented a catastrophic failure in the global financial system.
The conclusion by McKinsey was:
The tsunami has had little if any effect via (2), perhaps a small effect via (3), no effect via (4), little effect via (5), and a moderate drag via (6). That leaves (1)
It is somewhat curious the public sector has been the main beneficiary, after all, non-financial companies in the U.S., the U.K. and the eurozone have saved $710 billion on their debt service cost between 2007 and 2012 (mechanism 5).
This hasn't led to more investing as businesses haven't lowered their 'hurdle' rate (4) and credit for many companies (mainly small ones) is still tight. US business investment is at the lowest share of GDP since 1947 and in the eurozone it's not much better.
Households have been net losers ($630 billion) because of lower interest rates for savers. While there might be some offset from higher house and stock prices, these effects are small, according to McKinsey.
As you'll notice, the crucial part is the effect of QE on reducing "safe" interest rates, that is, bond yields. Most of the evidence show a rather limited impact (see here, here, here, here and especially here).
In Japan, QE has recently become part (the 'second arrow') of Abeconomics, and the success, at least initially, seems to be beyond that of other central banks embarking on QE. Japan has engineered a substantial devaluation of its currency, a large stock market boom (80%+) and bond yields have (after some initial wobbles) been rather well behaved (busting yet more short bets in what is clearly the world's longest running "widow maker" bet).
Most notably though, Japan seems to emerge from more than a decade of disinflation, and that alone would be a significant and positive achievement. There are two possible explanations for this relative success:
- The sheer size of the Japanese effort, the explicit goal has been to double the monetary base in two years
- The engineered effect on inflationary expectations, the aim is to bring inflation back to a positive 2% a year level.
In the academic literature on QE, the latter has been taken on special significance, as it is deemed as perhaps the more powerful channel and some argue that the effectiveness of QE is severely compromised if it doesn't succeed in shifting inflationary expectations.
How would shifting inflationary expectations work? Well, by simply reducing real interest rates (nominal rates minus expected inflation), which is especially useful if nominal rates cannot be lowered again (when they are bumping up the zero bound). Here are the Japanese inflationary expectations
The fall in the recent months has most likely been the result of tapering talk by the Fed. Even foreign central banks can influence inflationary expectations, it appears, although that probably only holds for the Fed.
Perhaps, as suggested in a paper by Iván Werning, if dramatic QE manages to positively shift expectations of future growth, this could have a significant impact on real spending. As Christina Romer argues:
Consumers who expect to have a job are far more likely to buy cars and remodel their kitchens than those who do not. And firms that expect to have customers are far more likely to build new factories and buy new machines than those that do not.
There are two main risks attached to QE, one that it will lead to accelerating inflation and the other that it creates asset bubbles. With respect to inflationary risk, here is part of an open letter to the Fed chairman three(!) years ago:
We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment.
However, if QE isn't deemed very effective in restoring economic growth, how can it be expected to lead to runaway inflation? It either has a substantial effect closing the gap between actual and potential output, which is when inflationary risks will increase, or it isn't effective but then we don't have to worry about inflation.
Since most of the QE money will produce real effects through bank lending, the Fed also has an effective, if crude way to contain these risks in the form of obliging banks to hold more reserves. Arguably, the main risk isn't inflation, but deflation, and one could argue that QE has been instrumental in mitigating these risks.
Bubbles and asymmetric risks
On balance, we are getting somewhat uncomfortable, the evidence increasingly suggest that asset prices are getting a little frothy:
- Bond yields shot up when tapering talk began
- Emerging market rout when tapering talk began
- Stock market setting new highs almost daily on the prospects of continued QE (bad news is good news)
So QE seems to be working asymmetrical, it hasn't really lowered bond yields all that much, but getting off it might do a lot of damage. Should that be reason to "taper"? Well, as the eurozone and Japan also show, deflation is also a non-negligible risk.
This is the famous "Greenspan" dilemma, what to do with monetary policy when there are no signs of inflationary pressures, but accommodating policy runs the risk of fueling asset bubbles. It's actually a rather awkward problem and it suggests something more fundamental is wrong with the economy if it can only run on cheap money.
How serious is the asset bubble risk? Well, it depends which market we're looking at. The bond market luckily has anchors in the form of risk premiums, inflationary expectations and expectations of future short-term rates. Bonds also have a finite time horizon with restitution of the principal at maturity, which also puts a break on prices running away too much.
For that to happen, something drastic has to happen, as a dramatic acceleration in inflationary expectations or risk premiums (which we saw a couple of years ago in the eurozone periphery when the markets woke up to the fact that they weren't guaranteed by the ECB, until it assumed its lender of last resort function, sort off).
So when countries have their own currency and inflation isn't spiraling out of control, it's unlikely that bond markets will be liable to extreme swings. Housing and stocks are more risky in this respect. We just had a housing bubble, another one isn't immediately obvious, so that leaves stocks.
Whether there exists a stock market bubble is debatable:
- Stocks are not cheap, but not exorbitantly expensive either, not yet anyway
- Profits and cash levels are at record levels
- Stock buybacks are at record levels
Margin debt is also close to record levels, but according to Barry Ritzholtz, this isn't necessarily a danger sign:
Margin debt, despite the whining from certain camps, is not currently a problem. But a major reversal in margin often means that much less buying power underneath equities, or worse yet, forced liquidations. If and when that happens, look out below.
But stocks could quite easily continue to rise, only the prospect of a turnaround in U.S. monetary policy seems to worry the markets fundamentally. Do we need to worry about that?
Well, there are two mildly comforting thoughts:
- Stock markets are volatile, it's in the nature of things, any correction shouldn't be the end of the world, of course, the bigger the rise, the steeper the fall could be.
- Previous experience with shifts in monetary policy shows that sell-offs are indeed that, a temporary correction to price in the new reality (higher interest rates, or the prospect of these).
The latter point has been shown by Antonio Fatás, who studied two such periods where monetary policy was tightened, after the 1990s recession and after the 2001 recession:
1. After the 1990 recession, interest rates remain low until February 1994 when the Federal Reserve started increasing rates from a level of 3% to 6.6% in May of 1995.
2. After the 2001 recession, interest rates were lowered to 1% and then started to increase in June 2004 from that level to 5.25% in June 2006.
What happened to the stock markets during these periods?
Initially the stock market moves sideways. During the first year there are gains of about 1%. But the years that follow, and once the increases in interest rates have stopped we see large increases in the index -- interest rates stopped increasing in the first episode 12 months after they started going up; in the second episode it happened about 24 months later. This is more or less when the stock market starts its climb.
That's not too scary. Whether this time will be different remains to be seen. On the one hand, this time around monetary policy is much more expansionary (there wasn't any QE in these previous two periods), so the reversal will be more monumental. On the other hand, monetary policy is only going to change when the economy is on firmer footing, in which case there should be a compensating increase in company earnings.
The one scary thought we have is what if the economy doesn't return to a "firmer" footing and policy makers will have problems reversing monetary policy? That scenario isn't all that unrealistic, as it happens, but that will have to wait for another article. We could be really hooked on QE, as it happens..