Monetary Policy Primer: QE

A primer on Monetary Policy – Quantitative Easing (QE)

When faced with a recession the orthodox approach to monetary policy is for the central bank to reduce the reference cash rate and if necessary, provide temporary liquidity through offering credit lines and direct purchases of government securities.

The ability to employ orthodox policy has however been severely compromised by the measures employed during the GFC by central banks internationally that remain in place to this day.  Namely the reference cash rate was not restored to pre-GFC levels and temporary liquidity measures were sustained with central bank balance sheets extended.

Central banks are therefore unable to deliver the 500-basis point or more reduction in the reference cash rate that would have provided relief and even stimulus in a normal recession.  The increased credit spreads associated with the higher risk of default would typically have been more than offset by the reduction in the reference cash rate leading to lower borrowing costs for corporates and reduced mortgage rates for households.  Instead less than a 100-basis point reduction in the reference cash rate was available to most central banks and at best, the interest rate for good quality credits and prime mortgage rates held their own while poor quality credit rates increased substantially.  The reference cash rate had become an impotent policy tool.

Quantitative easing (QE) has therefore become the central bank policy prescription of choice.  This involves the direct purchase of debt and more recently other instruments by the central banks.  An orthodox policy prescription would see this as a temporary measure with any instruments so purchased being either sold back into the market or held to maturity.  However, as already noted QE has resulted in the securities so purchased remaining on the central banks balance sheet with little prospect that they will be redeemed near term.

What then are the short and longer-term consequences of QE?

Firstly, the central banks have provided liquidity to the finance sector and by buying longer term government securities flattened the yield curve resulting in lower rates than would otherwise have prevailed.  This provides an immediate benefit to both governments, corporates and households through lower finance costs.  In exchange the central banks have taken on the default risk of the securities and signalled to finance market participants that you have a put option to the central bank as the buyer of last resort and therefore need not  concern yourself with default risk.

Governments can borrow more freely as they are not paying a default premium and therefore are not as accountable as to return, if any they are generating from their spending in excess of taxation revenues.  Should the government fail to generate a return on their borrowings (either directly or through the increased tax revenues derived from their outlays) the default risk increases and will surface in either a) higher interest rates for their borrowings and potentially the associated need for increased future taxation or b) increasing default risk borne by the central bank ultimately leading to the monetarisation of the debt with the risk of rampant inflation if confidence in the monetary base is undermined.

To date QE has simply led to central banks bearing increasing government default risk.  Confidence in the monetary base has been maintained with apparently few financial sector participants currently concerned about the risk of monetarisation.

Enter Covid-19 and QE has been put on steroids. 

Central banks are now not only buying government securities but also investment grade corporate credits, mortgage backed securities, junk bonds and exchange traded funds.  The central banks are arguing that they are providing liquidity but what they are doing is taking on the default risk of the underlying securities, inflating asset values and thereby providing market participants with little incentive to be discerning about investment quality.  Again, the consequences are that the beneficiaries of this largesse will be able to refinance and/or borrow more at a lower cost and have a reduced accountability for immediate performance.  Should the beneficiaries fail to deliver an appropriate risk adjusted return the default cost will be borne by the central banks who will bear the economic loss.  The economic loss will in effect be reflected in the moribund performance of the beneficiaries who will be sustained on a diet of subsidised loans and the effective monetarisation of losses sustained by the central bank on the holdings of the associated securities.

The exit strategy for the central banks will be determined by the politics.  As such the solution will need to address the bias favouring existing institutional arrangements and incumbents deemed too big to fail.

An austerity option will see the central banks gradually reverse QE and the associated excess liquidity.  This will allow asset values to reflect required risk adjusted returns and interest rates to once again signal and reflect required returns and default risks.  Governments would be required to cut their cloth, increasing taxation and selectively reducing expenditure while the private sector will see financial hardship, defaults, reduced asset prices and business restructurings before underutilised human and physical capital are appropriately redeployed.  Savers and astute investors in real businesses will be rewarded as real returns will be high. 

The easy political option is however monetarisation of the debts.  The central banks will maintain their bloated balance sheets.  Ultimately, they will either incur significant impairment due to defaults or continue to grow thereby perpetuating the discontinuities and distortions in the capital markets that QE introduced.  Governments and favoured institutions will continue to incur debts that they may not be able to service thereby commanding resources that under more orthodox policies would be available to others in society to deploy more productively.  With governments and large institutions favoured society will be less dynamic.  Lower productivity, higher inflation and continued financial hardship will be the consequences but expect fewer defaults and higher asset prices.  Confidence in the monetary base will wane and demands for compensation for non-asset price inflation will rise.  Savers will be disadvantaged as real returns will likely be negative after tax and even astute investors will struggle to discern the real economic signals from the nominal prices.  The real growth trajectory may be higher in the near term as expenditures are brought forward but will be significantly lower longer term than would be the case under the austerity option due to relative inefficiency of resource allocation.

In choosing their exit strategy politicians and central bankers should bear in mind that austerity is a burden that can be equitably borne but inflation is insidious and in its most harrowing form risks tearing asunder the very fabric of civil society.  

Bevan Wallace, Morgan Wallace Limited