Quantitative Easing: Will It Work?

Bond Market Reaction to Quantitative Easing (QE)

Long-term bond yields around the world have been rising recently. Is this because the “green shoots” of recovery are apparent and  investors are moving to increase exposure to risky assets or  is it possible that despite the very low short-term overnight rates being set by major central banks around the world investors are choking on bond supply?

Several governments have started down the route of quantitative easing led by the US Federal Reserve.  A notable exception has been the European Central Bank (ECB), where the unwieldy nature of the Governing Council has led to speculation of bickering and deadlock, with some members pushing for more aggressive policy while those from the Bundesbank school are fighting to hold off cutting rates below 1% or moving to aggressive non-standard measures.

Quantitative easing is a policy that was developed as a response to a significant increase in real interest rates that occured in the United States during the Great Depression. As has been widely studied by economists, starting with Milton Friedman and Anna Schwartz in A Monetary History of the United States, the large contraction in money supply in the US during the 1930′s and the failure of the Federal Reserve System to counteract it, was largely responsible for the depth and length of the depression.

While, in recent history, central banks have preferred to target money supply growth through targeting of official overnight rates (allowing daily monetary aggregates to fluctuate rather than allowing interest rates to fluctuate), economic historians observed that nominal interest rates might approach zero but with deflation, real interest rates might be quite high, inhibiting a recovery in the real economy. In fact, just this problem came about again in the case of the bursting of the equity and property bubble in Japan. Japan was slow to adopt more aggressive monetary easing. Only after it bailed out its banks and followed a policy of quantitative easing did the Japanese economy begin to recover. In the meantime, Japan suffered the lost decade of the 1990′s.

Fed Reserve policymakers, especially Chairman Bernanke, an economic historian who had studied credit intermediation during the depression, were very aware of the problems that Japan had jump-starting its economy. The Fed even held a symposium on this topic at one of their annual Jackson Hole retreats.  During the Japanese experiment with QE, the government was successful in flattening out the yield curve lowering longer-term interest rates. However, it has been criticized for injecting money into the banks which then hoarded cash.

The Fed decided to go about QE in a different way by purchasing debt in the secondary market. First they started with mortgage paper. This has been followed up by the purchase of government securities concentrated in the 2 to 10 year sector. Much blather has been written about the negative implications of the central bank  (whether in the US or the UK) monetizing debt. In fact, the Fed and Bank of England have simply been increasing money supply through open market operations just as they would have if they had been targeting overnight interest rates. The only difference is that when targeting overnight interest rates, central banks are constantly entering the repo market to increase or decrease money supply to keep rates nearly fixed. However, once interest rates are pegged near zero, they must instead target money supply directly.

The Taylor rule, a rule developed by John Taylor of Stanford University, describes both how central banks typically act and as a prescriptive formula for how they should act. Fed staff currently believe that the Taylor rule, given current economic conditions,  would imply a negative 5% overnight interest rate were that possible. So quantitative easing is absolutely necessary to increase money supply sufficiently to stave off a deflationary downward spiral accompanied by a  surge in real interest rates.

However, the bond market has seen yields backing up, not just in the US, but around the world. The only historical evidence that quantitative easing can affect the shape of the yield curve was the experience in Japan. Earlier academic studies of  “Operation Twist”, conducted during the Kennedy administration, came to the conclusion that trying to change the shape of the yield curve was ineffective. A basic tenet of economic policy is that one needs as many tools as policy targets. Given only a single tool of monetary policy (i.e. the supply of high-powered money) which is targeting an increasing in money supply, it seems unlikely that it could also control a second variable like the shape of the yield curve.

Instead, what seems likely is that the recent bear steepening of yield curves around the world is a reaction to the massive and simultaneous deficit financing by every major industrialized country.  It is hard to find a comparable period in the past where every government has tried at the same time to massively increase debt. Moreover, these increases in debt dwarf the quantitative easings being undertaken.

We do know, however, what happens when governments increase debt issuance. We have only to look at the experience of German re-unification. This was a hugely expensive episode for Germany with the issuance of large amounts of Treuhand bonds. In order to attract capital to purchase these bonds, real yields in Germany rose. The value of the Deutschemark also rose in the foreign exchange markets as investors bought Deutschemark’s in order to capture these high yields. Now imagine a situation of a couple of orders of magnitude greater than that. We may see the biggest debtor nations (including the UK and the US) see their currencies appreciate and their bonds yields rise significantly. Both effects will lead to a significant drag on any recovery, in turn making their deficits worse.  Meanwhile those countries like Germany that have been reluctant to spend on stimulus will still reap the spillover benefits of stimulus in other countries, while enjoying lower domestic bond yields and a weaker currency. Of course, given the current inaction of the ECB, Germany may need the weaker currency and lower bond yields.