Does quantitative easing deserve to come out of the sin bin?

After slightly disappointing inflation figures last week, the European Central Bank is bound to be cautious in its assessment of the interest rate environment on Thursday. I look at the likely forecast changes below. The main section today examines the emerging international evidence in favour of quantitative tightening. And if QT works, that strengthens the case for quantitative easing (or money printing). Does the tool deserve to come out of the sin bin? Email me: chris.giles@ft.com

Effective QT makes the case for QE

I am writing this newsletter mid-Atlantic on my way back from Friday’s rather excellent US monetary policy forum, organised by the University of Chicago Booth School of Business. The main topic of the day, discussed by a select audience including many members of the Federal Open Market Committee, was the international effects of quantitative tightening.

Remember, quantitative easing is the process of central banks creating (printing) money and buying assets, mostly government bonds, and in the process both removing stress in financial markets and stimulating demand. It appears to work in practice by lowering borrowing costs for governments, facilitating higher sovereign borrowing and reducing longer-term interest rates for the private sector (different people put different weights on these arguments).

QE has a pretty bad reputation at the moment, however. Money creation is blamed for the great inflation of the past few years, but this is valid only for the length of time it was continued, according to the vast majority of studies. It is accused of undermining government finances because central banks are paying higher interest rates on the money created than they receive on the assets they purchased. It is seen to be maxed out, with central banks owning about a third of their government bond markets. And the evidence has been that QE is difficult to reverse, with the Federal Reserve running into difficulties between 2017 and 2019.

If central banks can demonstrate that effective QT can reverse QE without many harms, it would rehabilitate QE. The irreversibility argument would die, central banks would create more space for future QE and the fiscal costs would be shown to be temporary. The inflation question would still exist, but probably become limited to questions of whether central banks kept the printing presses on too long, rather than whether it was fundamentally dangerous for prices.

The discussion was based around a new paper by Wenxin Du, Kristin Forbes and Matthew Luzzetti. Collating all the relevant evidence from the US, eurozone, UK, Sweden, New Zealand, Australia and Canada, it is a marvellous resource, even if you are appropriately sceptical of the precise results. The chart below shows the progress to date of QT in reversing QE, which can be described as significant but not yet substantial. The US, eurozone and UK have done the most QE relative to gross domestic product; the UK stands out for its concentration on government bonds, and all countries’ central banks owned a large proportion of their government’s bond markets.

Forbes wrote an article summarising the main results in the FT yesterday, so I can focus more on the discussion that arose from the results. The main finding was that the effects of QT were, in Forbes’ words, “very, very tiny”. Yes, the authors did find a statistically significant effect of QT announcements on government bond yields, but these increased borrowing costs in a range between 0.04 and 0.08 percentage points. That’s a range of basically nothing to practically nothing. To scale it appropriately, the US 10-year treasury yield rose more than twice as much after moderately poor January CPI figures were released on February 13.

To be more specific, this is an event study that looks at every two-day movement in bond yields — about 15,000 of them across the seven countries — and asks whether there was anything special about the 34 periods when there was some sort of announcement about QT. So, it really examines whether financial markets feel they learnt something new on these days.

The finding that QT new days were not much different from other days is good, however. Similar studies of QE showed much larger effects of asset purchases in decreasing government bond yields, in the order of 0.16 to 1.49 percentage points. This means the evidence suggests that printing money surprises markets in a good way, lowers interest rates and helps out in stressed situations, but removing it does not have the reverse effect. On the face of it, QE is therefore a policy that works and can be removed painlessly. As Treasury secretary Janet Yellen said in 2017, it is about as interesting as “watching paint dry”.

The room was full of economics nerds, so no one took the results at face value, including two FOMC members — Lorrie Logan, who heads the Dallas Fed, and Christopher Waller, a Fed board governor. This discussion was the most interesting element.

The first critique is that QT was fully anticipated by markets following hints and preliminary discussion so it was not surprising that the results of QT announcements were so tiny. The authors had anticipated that challenge and also looked at market reaction around preliminary discussions of QT, but these did not show market moves either.

A second possibility was that QT had little effect when announced but more when being implemented, so the authors looked at this too. Again, nothing.

Logan said she thought the asymmetry between QE and QT effects could be explained by financial markets anticipating QT better than QE, which was understandable because the latter was implemented at times of stress and brought sudden relief, while QT happened in calmer moments. In fact, she said “the main reason we measure larger liquidity effects on average from QE than QT is that central banks don’t use QT when it would have large liquidity effects”.

Waller amplified this point, saying “central banks timed QE and QT in the right manner such that society was better off”.

These critiques must be true. Otherwise, QE would permanently lower bond yields even after it has been reversed, and that is a nonsense. So the conclusion must be that QE announcements can work and, so long as they are carefully calibrated, QT announcements do not scare markets. Government bond yields do rise again, but probably when the central bank raises interest rates and not when it announces QT (although that can be difficult to disentangle because the announcements often happen simultaneously). Central banks can use QE to stimulate economies when interest rates have fallen to zero and the policy has power, especially at times of financial stress, and they can then reverse it with QT at leisure in the background when interest rates are positive.

One quick digression. Because central bank actions are often anticipated, this rather destroys the statistical underpinnings of any of these announcement effect studies for QE and QT. The best way to analyse the true importance of QE, for example, would be for officials to lead markets to believe the Fed or other central banks would act at a time of stress and then for the central banks to announce they were going to do nothing. The resulting bond yield turmoil (or not) would give an accurate indicator of the importance of central bank intervention. Great for statistical inference, bad for economic policy. The closest we have got to a natural experiment on these lines was when Congress rejected the Tarp bank bailout in September 2008. It wasn’t pretty.

The upshot is, I think, not to take the results of this study seriously or literally, but conclude that it gives some evidence that QT is not noticeably causing harm and that interest rates can be the central bank’s primary tool for tightening monetary policy. Reading more into it than that would be a mistake.

Next week I will look at the more difficult question of whether QT will continue to work so well, but in the meantime, enjoy the week.

What I’ve been reading and watching

• The Bank for International Settlements is relishing its job as the destroyer of dovish dreams. In its latest quarterly review it suggests high services inflation has some way to go and officials should be cautious about cutting interest rates. The BIS can be wrong, of course, but it is a useful challenge

• Two big central bank personnel announcements happened in the past week. Thomas Jordan said he would step down from the Swiss National Bank after 12 turbulent years. Clare Lombardelli, the former Treasury official and OECD chief economist, has been named as the next Bank of England deputy governor for monetary policy, creating a majority of women on its Monetary Policy Committee for the first time since it was created in 1997

• Unhedged has run a fascinating interview with Adam Posen, head of the Peterson Institute for International Economics, in which the Europhile Posen sounds quite bullish about US productivity. The transatlantic difference in mood over productivity is quite remarkable. Europe is mired in gloom; America celebrates a boom

• Speaking of miserable Europeans, I’ve heard a whole bunch of nonsense about economic effects of the brief premiership of Liz Truss, much coming from the former prime minister herself. I snapped and wrote about the lasting and pernicious effects of her period in office. Nothing to do with interest rates, but it has given radicalism a very bad name

A chart that matters

The ECB will publish new forecasts on Thursday, probably showing a reduction in near-term growth because confidence in Europe is not anything like as strong as in America. As ever with incremental forecasts, most of the movements will come from changes in the conditioning assumptions that have occurred since the previous publication in December. The chart below highlights the key changes in the conditioning assumptions taken from mid-February. Lower gas and electricity prices will depress the inflation forecast a lot in the near term. But because interest rates and cheaper energy will stimulate demand, growth is likely to be revised higher in the medium term, also pushing up more distant inflation forecasts.

Source: Economy - ft.com