Yesterday saw another strong day for equity markets which continued a recent trend. We saw another triple digit rise for the American Dow Jones Index albeit only just with it up 100.81 to 10,525. The S&P 500 index which I mentioned in yesterdays article rose to 1115 which is up 5% since the lows of last Tuesday. There was also the beginning of news emerging as analysts used the European Stress Test data for their own purposes. For example there is a new criteria being set out of Basel which has been suggesting new capital ratios and criteria for worldwide banking. Now this is not yet in operation but if it was then 39 not 7 banks would have failed. The essential difference is that some 8% of Tier 1 capital is required and not 6%. After the last few years my faith in banking regulators is less than total but it is higher than my faith in euro zone officials.
I was asked a question on this subject and replied to it on here over the weekend. There is some further news on this subject in terms of new research so I thought I would discuss this today. In terms of relevance we saw the Chairman of the Federal Reserve Ben Bernanke say this last week in his speech to Congress.
we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability
The Committee considered arguments in favour of a modest easing in the stance of monetary policy.
Ordinarily we would take this to me an interest rate cut was likely but both countries have extraordinarily low interest rates already with the US operating at between 0 and 0.25% and the UK base rate being 0.5%. So more asset purchases were on the cards or at least being discussed at the last meetings of both central banks.
My View on how QE has worked with particular emphasis on the UK
As to buying your own bonds which both the UK and US have done recently there are two main issues. We both have to sell some of our government bonds abroad. That does not mean that we do not have domestic savers or pension funds that do buy them merely that we do not have enough. Indeed with the large expected deficits we both have then we are likely to be rather reliant on overseas purchases of our bonds over the next few years and we both have overseas holders of our existing bonds (around 30% in the UK). Think of it now from their perspective. They know that this is a risky experiment and they must to my mind have a lower view of us then before. So there are dangers here for their willingness to invest in us in the future. I thought that this would impact this year on bond yields but I have been proved wrong as spring turned to summer by the way that “flights to quality” effects have affected both US and UK bond yields favourably. So I feel that we will have to wait for the full impact of this until the world economy begins a more sustained recovery and risk,fear and contagion are no longer driving forces. Put more simply I think that it has been a fluke that Quantitative Easing has not been viewed more unfavourably as the political stability and safe haven status of the UK and US has outweighed “bond economics”.
Another way of thinking of this is saying why do you not buy your own mortgage? The problem then is getting people to trade with you and give you credit etc. Of course you may have to get them to stop laughing first at the idea…
Now if you look at the second issue which is the domestic economy. If we ignore the concept of sterilisation and look at pure QE then what is happening if you buy your own bonds? The first move is that your central bank is creating money and exchanging it for debt. So the money supply is expanded. There are many different theories on what the impact of this is but if you pump extra money into an economy there are two main possible effects a rise in output and/or a rise in prices. I personally feel that the links between pumping this sort of money into the economy and output are weak at best and that this has so far been demonstrated by how the US and UK economies have responded. However there have been signs of an impact on prices in the UK (and if you read my article on US inflation more there than you might think). To my mind there clearly have been effects on asset prices such as the stock market and in the UK on house prices and maybe in some commodity prices which are to my mind much higher than you might expect considering the fall in world output. So even at a time when you might think that expanding the money supply is least likely to raise inflation I would contend that it has done so, and I am using a wider definition of inflation here than just a consumer price index.
Now here is a question which I do not believe those in favour of buying your own bonds have ever properly answered. When things get better what is your strategy?
I hope that this helps. There are issues here that do not have a definitive answer. The phrase “a dismal science” does apply to economics here, not necessarily that all of it is dismal but that you never actually get a definitive answer in the way that a scientific experiment might give you. You can never factor out one variable and isolate it as there are always other factors. For example if we take money supply you might think that this is easily calculated but once you get from base or high-powered money (which the central bank sets and therefore should know) it is often not so clear how you define things and then calculating it.This is rarely discussed but is true, I suspect it is rarely discussed because many of those who look at it do not understand it. So far with the lags in monetary policy the QE experiments in the UK and US have probably had about 2/3 rds of their effect so some is still unknown…
As to buying your own bonds I think part of the answer comes from thinking of it as a complete concept, as in if it is such a good idea why has it not been done before and why do we and the US not buy all of our own bonds? We need not bother then with such inconveniences as foreign investors and adverse change in interest rates, we could set whatever ones we liked. Here I think becomes the beginning of the rub to me as in it is a part of a fantasy that currently exists in the real world.
A Further Factor
One influence of a bond buying programme by a nation or QE is that the prices of its debt tend to rise or put another way the yields fall. The proponents of such a policy believe that this will lead to a more general fall in long-term interest rates which will benefit businesses if they issue new tranches of such debt. Also those taking out mortgages may be encouraged to take out longer-term fixed rate ones. If we look at the UK evidence the our ten-year government bond yield fell to around 3.1% leading observers to estimate a positive impact on long-term yields of around 0.75%. It was hoped that this would benefit an economy.
However in the UK banks increased their margins and also raised the amount of equity required to get a mortgage and the corporate sector did issue new longer-term debt but it remains a small part of the whole. So the benefit may have been low. Of course the government did gain as it issued a whole years debt (actually slightly over) to itself at low interest rates.
As time has gone by though we have seen a new situation as UK longer term gilt yields fell to nearly 3.3% in June/early July of this year. Whilst the stock of bonds bought is still in existence there has been no new buying for quite a few months. It makes me wonder if during the economic slowdown yields might have fallen anyway. Of course that there is an alternative scenario whereby existing investors were more than happy to see prices rise so that they could sell to the UK taxpayer at an expensive level.
A More Hopeful Alternative
It will hopefully be clear that I consider the QE experiment in the UK to have been a policy mistake and that some of the implications of the mistake are yet to come. However there is a better way. The Federal Reserve in America used it more which is to buy private-sector assets. The Bank of England had this option but choose to use it very sparingly and in fact it could still buy up to £50 billion of them if it financed it by the sale of Treasury Bills. So not quite pure QE but long-term assets would be bought.
This to my mind is much more likely to succeed in my view as you are directly buying private-sector assets and therefore are directly supporting prices. The rise in prices will lead to a fall in yields which means further debt issuance will be cheaper and thereby encouraged. There is a clear route here to a benefit to the economy. Because such markets in the UK are small relative to the size of our economy then the size of such a policy would be kept contained.
An Even More Hopeful Alternative
Actually if we ever really faced an economic calamity such as a genuine prospect of a severe double-dip or a 1930s type scenario I would follow Keynes example. This would involve creating money at the central bank and giving it to people. As both the British and Americans are avid consumers and spenders I think the next link in the chain is clear. Sometimes simple really is best. It is something of an irony that Ben Bernanke has acquired the nickname of “Helicopter Ben” as that is precisely what he did not do.
New Research on QE
Vasco Curdia and Micheal Woodford at the NBER (National Bureau of Economic Research) have written a working paper on this subject and here is taste of their views.
We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached.
I notice the “likely to be ineffective at all times” verdict on QE. No wonder the Bank of England keeps coming up with new explanations for it.
I have been asked a couple of questions on this subject. The first enquires as to what is a safe level of QE.That to my mind is easily answered the problems start at 1 and get higher as you increase. Now plainly in itself £1 or $1 would not have any measurable impact but with apologies to George Orwell all pounds are created equal….
with potentially “too much” money out there in the banking system from Q.E. but inflation not yet really hitting, what might be the mechanism and trigger for it to take hold? And when that happens is there anything a Central Bank could do about it at that stage?
Starting from the beginning do we have too much money? At the level of the monetary base or high-powered money then yes we do as central banks have poured money into these areas to try to jump-start economies. Those looking at monetary statistics would be looking at M1 or M0 measures here. However as we go into wider measures and also look at bank lending we have too little. So the real problem is a dislocation in the system. An analogy is a patient on a hospital trolley with a heart attack and the doctor pumping electricity into him/her but not getting much response.
To move forward to the final section then should this change it is likely to do so much too quickly for central banks to respond. In the medical analogy the patient will come alive and start breathing etc. instantaneously. Now if we replace the Doctor with a Central Banker what will he/she do? I believe we will get a huge sigh of relief followed quickly by the thought we had better hang on in responding, we do not want to be responsible to ending/curtailing an incipient recovery. In this gap inflation may well get into the system and the Central Bank will then be too late responding. There are lots of implications to this but for now I think it is best to remain with just one, central banks will respond too late and if you read their statements this is in fact a policy move. This to my mind is a serious criticism of the current crop of central bankers. Their job specification involves the control of inflation and yet many central banks currently would be grateful for it. My view on this is that it is something of a betrayal and a bit like a fireman turning out to be an arsonist.
I like to offer a solution. To my mind there is not one in conventional Central Banking action. The dislocation in money supply is between narrow and wide measures at this time and this is particularly wide in the US where shadowstats numbers for M3 are scary. My response would be to reform the banking sector. I know this is not a conventional response but to get things moving we need to get bank lending and hence the banking sector operating again. The saddest part of the lack of reform is that we are in danger of learning nothing at all from what happened in Japan in the 1990s.
My question to the proponents of QE and QE2 is as follows. What is your endgame?
As a further thought I have something which is rather chilling so those of a nervous disposition may like to look away. If we go back in time then our current problems had other factors influencing them than the usual conventional analysis provides. So if you would be kind enough to suspend the usual “epoch breaking” analysis for a moment please consider this. Two rather ordinary factors were at play.
1. Interest rates surged inspite of official levels. In the UK,for example, three-month money stayed at 7% for quite some time. So one rather ordinary factor was simply interest rates being inappropriately set as in much too high for the circumstances. This would have had quite a contractionary effect and central banks were very slow to deal with this.
2. The oil price shot up reaching a peak in July 2008 of US $145. Now there is a lot of debate over why this happened but there are plainly two issues. One is that an increase in the oil price of this size would in itself have had quite a strong impact on world output. It also impacted at a time when the inappropriate interest rates in point 1 would have been hitting hard too.
So inappropriate interest rates and an inappropriate oil price. Does the fall in world output look so extraordinary now? You see if it doesn’t then it begs the question was the extraordinary response necessary? I am left with a rather chilling thought that it was for the banks (to carry on pretty much as they were as far as I can tell) but may not have been for the rest of us.