It is now clear that QE was a colossal political mistake

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The big quantitative easing experiment was a mistake. It is time for central banks to recognize its failure and remove it from their policy arsenal as soon as they can.

Since the global financial crisis of 2008, an integral part of the playbook of central banks in the United States, United Kingdom and European Union has been QE – the practice of buying long-term bonds and mortgage-backed securities. QE is supposed to work by lowering long-term interest rates, which stimulates demand and increases lending and risk-taking.

There’s little to show in terms of the economic benefits of QE, but there are a lot of costs. Now central banks have their hands tied as they attempt to rein in inflation with interest rate hikes and quantitative tightening, which means no more bond buying at all. term and mortgage-backed securities. But they find that the end of QE may in itself pose a threat to financial stability.

During the 2008 financial crisis, central banks were desperate to inject liquidity into the financial system. With the key interest rate at zero, it had to find another mechanism, so it bought long-term bonds and mortgage-backed securities, swelling its balance sheet. It was supposed to be an emergency measure, but it went on for years. QE was followed by QE2 and then QE3 as the Fed feared the shutdown would crash bond markets.

About a decade later, as the Fed’s balance sheet finally began to shrink, the pandemic and the biggest QE of all time arrived. It lasted long after the immediate crisis was over, even as inflation and the housing market began to heat up.

Looking objectively at the evidence, it’s still not clear that all of these bond purchases ever did much for the economy. As Ben Bernanke once said, “The problem with quantitative easing (QE) is that it works in practice but not in theory”.

In cases where a market is in trouble, the fact that the central bank intervenes and buys bonds can provide the necessary liquidity. But using QE to stimulate the whole economy, reduce unemployment or stimulate inflation, has a more dubious track record. A study, titled Fifty Shades of QE, assessed the many research papers that measure the impact of QE on the economy. He found that all of the research from central banks sees QE as a great success, but only half of the research from academics finds benefits for economic output or inflation. When they find a benefit, it tends to be lower than bank research claims.

In the meantime, there are significant costs. First there are the direct costs: QE is essentially taking a leveraged bet that won’t pay off if interest rates rise. The Fed pays interest on the reserves it holds for banks, and it uses those reserves to fund its long-term bond purchases. Now that the interest rate has risen to fight inflation, the Fed has to pay more for reserves than it receives from bonds in its portfolio and losing money.

The indirect costs of QE could be even worse. The use of QE to keep interest rates low distorts risk assessment since bonds are considered the risk-free assets of the economy – they are used to price assets and act as a barometer of risk taking. risk. Long-term bonds are among the most consistently important assets in the economy, and when their price is distorted, risk prices make less sense.

The Bank for International Settlements published an article claiming that lower long-term rates made corporate debt cheaper, supporting zombie companies. Fed interference in the mortgage-backed securities market during the pandemic could distort the housing market for years.

Hanno Lustig, a finance professor at Stanford Business School, fears that cutting government borrowing rates is “blocking the signal” that markets would otherwise give when the government is borrowing too much. “Bond traders have an incentive to invest more in determining what the central bank will do, less in determining what [market] the fundamentals are,” he said.

QE blurs the relationship between fiscal and monetary policy and threatens central bank independence because the Fed essentially monetizes government debt. It also makes it very difficult to comply with monetary policy rules.

There has been a longstanding debate among macroeconomists about how the Fed should conduct monetary policy. Should he simply respond to conditions as they unfold, based on the monetary policy currently in fashion? Or does it have to follow predefined rules based on data, such as setting the interest rate with a formula that takes into account inflation, unemployment and GDP.

Many economists believe rules are better in most situations because they maintain the Fed’s credibility and promote transparency. There is no such formula or rule for EQ; it is always punctual. This may be necessary in an emergency situation like financial crisis. But the continued use of QE shows that central bankers will then expand this emergency action in normal times.

Ending QE will not be easy. Central banks now have huge balance sheets that will take years to shrink. And as we see in the UK, when a central bank stops buying bonds, it can throw markets into chaos. Now that QE has become the norm, the next time there is a recession, markets will expect more QE, and if that doesn’t happen, it could cause more problems in the debt market. .

This is why central banks have to admit that QE was a mistake. Their credibility is already at stake after underestimating inflation. Now is the time to take a hard look at the monetary policy of the past decade and rethink what has worked and what hasn’t. Otherwise, we’ll be stuck with QE forever.

More other writers at Bloomberg Opinion:

A soft landing is in sight, but can the Fed stick to it? : Levin and Miranda

Peak looms, but markets may overdo it: John Authors

Central banks take a break but can’t rest: Mohamed El-Erian

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Allison Schrager is a Bloomberg Opinion columnist covering the economy. A senior fellow at the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk”.

More stories like this are available at bloomberg.com/opinion

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