After the stock market crash of 2008 and the ensuing Great Recession, a theoretical challenge to monetary policy became reality in the United States and throughout the Eurozone. Proposed by John Maynard Keynes in the 1920’s, a “liquidity trap” would arise when target interest rates are set so low that people cease investment altogether and instead hoard their money. This, in turn, would cause interest rates to remain low as the demand for loans falls, and prices decline even further, towards a dangerous deflationary spiral. With the Federal Reserve in the U.S. tapering quantitative easing (QE), and even raising interest rates, markets are recoiling and beginning to fall around the world.
At the March 2016, conference in Davos, much attention turned to the role of central banks in a post-Recession global economy and with the allusion that quantitative easing in all of its forms had failed to produce the outcomes desired. As such, with world markets on the verge of bear markets, and economies on the brink of renewed recession, the implication of the QE experiment will remain murky for some time.
Following the March 2016 discussion, the Bank of Japan took the extreme measure of enacting a negative interest rate policy (NIRP) to stave off deflationary pressures after its QE efforts have run out of steam.
What is clear is that central bank policy since the great Recession is not a temporary patch but, a fixture of global economic policy.
A History of QE
Typically, a central bank can step in to halt deflation by enacting expansionary policy tools, however, if interest rates are already very low, there is the technical constraint bounded by a zero per cent minimum nominal rate.
After traditional methods have been tried and failed, the central bank is left with little choice but to engage in unconventional monetary policy in order to dig the economy out of the liquidity trap, and encourage renewed investment and economic growth. In November of 2008, the Federal Reserve initiated its first round of quantitative easing (QE1) by purchasing mortgage backed securities (MBS)—decidedly not a government security. The aim was to prop up the asset values of these “toxic” instruments in order to prevent a collapse of the financial system, which had massive exposure to what it thought were high quality securities. Rated ‘A’ or similar by debt ratings agencies, investment banks and buy-side institutions alike found their balance sheets laden with MBS, which became worthless paper after the housing market collapsed and the financial markets crashed.
While unprecedented in the United States, the purchase of non-government securities by a central bank had been previously tested by the Bank of Japan (BoJ) in the early 2000’s (Spiegel, 2006). Facing its own liquidity trap and persistent deflationary pressures, the BoJ began buying excess government securities, effectively paying an implied negative interest rate on Japanese government bonds. When this failed to stoke inflation, the BoJ began to purchase asset-backed securities, commercial paper and eventually outright shares of stock in Japanese corporations.
Ultimately, the effectiveness of Japan’s QE on stimulating the real economy was less than hoped for. Currently, the Japanese economy has entered its fifth recessionary period since 2008 and is experiencing a bear equity market, despite the renewed QE efforts of “Abenomics.” Interestingly, prior to enacting its first round of quantitative easing in 2001, the Bank of Japan had repeatedly dismissed the effectiveness of such measures and rejected its usefulness in practice. The “lost decade” that Japan endured, despite repeated attempts to prop up asset prices, may not be entirely surprising.
The U.S. Federal Reserve Bank also did not stop with one round of quantitative easing. When $2.1 trillion worth of MBS purchases failed to keep asset prices aloft, QE2 was rolled out in November of 2010. And in December 2012, the Fed debuted QE3. To put all of this into perspective, in 2007, prior to the crisis, the Federal Reserve system held approximately $750 billion worth of Treasury securities on its balance sheet. As of October, 2017, that number had swelled to nearly $2.5 trillion. Moreover, the Fed still maintains over $1.7 trillion of mortgage securities on its books, where previously it held effectively zero.
QE Boosts Asset Prices and Risk Tasking
Fed Chairman at the time, Ben Bernanke (2009), recognized that the Great Depression of 1929, which lasted more than a decade, was such a severe economic downturn because the central bank had failed to act to stabilize prices when it could have. According to many, the crisis of 2008 – 2009 would almost certainly have been deeper and more painful had it not been for quantitative easing, as well as the fiscal policy introduced by the Troubled Asset Relief Program, or TARP, allowing the U.S. Treasury itself to purchase securitized assets as well as publicly traded equity.
According to a 2009 report by the International Monetary Fund, quantitative easing greatly reduced systemic risk which would have otherwise crippled markets as well as restored investor confidence. Researchers have found evidence that QE2 was largely responsible for the bull stock market of 2010 and beyon, and the Federal Reserve’s own internal analysis has shown that its large-scale asset purchases had played a “significant role in supporting economic activity.”
However, others, including former Federal Reserve Chairman Alan Greenspan have been critical, saying the quantitative easing had done very little for the real economy—or the underlying process of production and consumption. The experience of Japan and the United States brings to the forefront the question of whether or not central banks should still act to support asset prices, and what effect, if any, it has on stimulating actual economic growth.
If market participants know that the central bank can, and indeed will, step in to prop up asset markets in times of crisis, it can present a great moral hazard. Later referred to as the “Greenspan/Bernanke put,” investors and financial institutions alike began to rely on central bank interventions as the single stabilizing force in many markets. The rationale is that even if economic fundamentals pointed to a slow recovery and persistent low inflation for the real economy, a rational actor would still eagerly purchase assets knowing that they should get in before the central bank operates to bid prices progressively higher. The result can be excessive risk taking fueled by the assumption that the central bank will do everything in its power to step in and prevent a collapse in prices.
The irony is that markets will begin to respond positively to negative economic data, because if the economy remains subdued the central bank will keep the QE turned on. Traditional market analysis is suddenly flipped on its head as poor unemployment figures encourage asset purchases ahead of the central bank, and at the same time positive economic surprises cause markets to fall as investors fear an end to the QE, or worse, an increase in interest rates above its near-zero percent floor. This last issue has been of increasing importance through the second half of 2015 as the Janet Yellen-led Fed contemplated its first interest rate increase in more than nine years. While investors initially celebrated the rate hike decision, the S&P 500 has since fallen nearly 15%.
It can be useful to look at historical economic data to see what impact asset stabilization has had for the U.S. economy. For one, quantitative easing certainly affected asset prices positively. The U.S. broad stock markets enjoyed eight consecutive years of bull markets, with returns matching changes to the size of the Fed’s balance sheet. The 10-year and 30-year U.S. government bond yields also appear to have moved in line with asset purchases: yields widened as the Fed’s balance sheet expanded and have narrowed as the Fed’s balance sheet has stopped growing. For corporate bonds, spreads over Treasuries narrowed as the Fed was expanding its balance sheet and have since widened substantially as the Fed’s balance sheet has stopped expanding into the second half of 2017.
While asset prices have enjoyed a boost from QE, many aspects of the real economy seem to have been entirely unaffected. Consumer confidence, industrial production, business capital expenditures and job openings all bear no significant correlation to changes in the size of the Fed’s balance sheet. More to the point, economic output, as measured by changes to nominal GDP, seems to have very little relationship at all with quantitative easing.
The politics of asset stabilization and quantitative easing rests on two important questions: first, are such efforts legal in the first place, for example interfering with free markets; and second, does it open the door for central banks to claim “emergency powers” to gain undue control over monetary policy. The Austrian school of economics would predict that QE artificially stabilized prices through intervention, and now markets will fall to justified levels.
Still, most central bankers fear that the genie has been let out of the bottle—or Pandora out of her box—and that in order to keep stability going forward, QE must be a fixture and not a temporary patch. Central bankers also have an incentive to keep it up: emergency powers have created central banks that are now major creditors of national governments, and thus could potentially exert undue control over the purse strings of those governments.
Some economies, like the U.S., are growing in terms of the raw data, and its central bank needs to act accordingly to reign in monetary policy. But world economies today are intrinsically linked; even if the U.S. curbs back asset purchases, more will take place abroad. Foreign central banks, in fact, are now dealing with a lack of currency reserves with which to effect purchases. Taking a step back, perhaps a bigger question than whether or not central banks should act to stabilize asset prices in order to avert a larger economic crisis is: what happens when all the asset buying stops?