Are investors starting to see through quantitative easing?
It remains likely that the only way for QE to work is if it makes people believe the central bank has lost its inflation-fighting credibility. And that hasn’t happened yet. Although the time is getting closer.
Last week, the Bank of England said it would be buying yet more U.K. government bonds from the market; its total QE is rising to £375 billion ($580 billion) from £325 billion. The European Central Bank is holding off from bond purchases because of political hurdles but another mechanism is being put into place for European QE-lite, while the Bank of Japan is working through a 10 trillion yen ($125 billion) program announced earlier this year, as part of what is looking like perpetual QE, according to a commentary by the Sober Look economics blog in March.
And now, after some decidedly downbeat U.S. economic data including yet another drab jobs report for June, a growing consensus is that the Federal Reserve will launch QE3 when its policy-making body meets at the end of the month.
But the data show that successive rounds of heterodox monetary policy–like QE or Operation Twist or the ECB’s trillion-euro long-term repo operations–are having increasingly smaller and shorter impacts on market sentiment and, thus, on the underlying economies.
QE is meant to work by driving investors into riskier assets as central banks replace outstanding government bonds with cash and bank reserves that yield at most next to nothing. But holders of these other assets also know that while QE inflates their prices for now, any reversal of policy–once economies start to recover–runs the risk of sending the prices of those assets crashing back down to where they can be justified by long-term expectations, determined by official interest rates and risk premiums.
Of course, central banks hope that economic growth would be sufficient to support those inflated asset prices. But this seems unlikely, given lower trend growth rates in developed economies.
There is, however, one other way for QE to work in generating economic growth, which would also support nominal asset prices. That’s if people became convinced central banks have lost their inflation-fighting credibility.
But central banks did such a good job in the years following the inflation of the 1970s convincing investors of their determination to secure price stability that the only way investors would believe that central bankers have lost control is if their balance sheets become so enormous that there is no rational, reasonable way for them to constrain inflation–in much the same way that central banks couldn’t handle the effects of a deflating bubble, despite promises to the contrary.
And balance sheets are heading in that direction.
Post-crisis economics have been characterized by falling monetary velocity as borrowers have sought to pay back debts and banks have sought to tighten credit conditions. A sudden turnaround of money velocity against the backdrop of huge amounts of bank reserves would see a sudden and very dramatic spike in inflation as people sought to dump cash for any physical assets they could get hold of.
Good luck to central banks trying to stand in front of that locomotive.