Still uncharted territory – post-crisis central banking

ESSA Writers
monetary policy
February 14, 2014

With Janet Yellen firmly in the reigns of the world’s largest central bank, many are looking to the legacy left by her predecessor Ben Bernanke. Love or loathe him, Bernanke undoubtedly pioneered a new style of central banking based on large scale direct market intervention, mainly through policies such as quantitative easing. With the policy now being scaled down, it is useful to ask whether QE and more broadly whether the Federal Reserve has been successful in supporting the US recovery.

Does QE really work?

The most basic rationale for QE is to encourage investment and boost demand by lowering long term interest rates. To do this the Fed has been purchasing 10 year US treasuries at an increasing rate over the past few years. The policy was implemented by Bernanke as part of a more aggressive monetary policy stance, with the federal funds rate already at the zero lower bound.

In spite of the initiative and sound premise, the slow rate of recovery in prices and employment post-GFC has led many to believe the policy has no effect on the real economy. Prominent macroeconomists, Stephen Williamson and John Cochrane argue the policy is entirely neutral. They believe the Fed is merely restructuring the composition of debt by swapping long term treasuries with those of short term maturity. In a controversial Richmond and St Louis Fed research paper, Williamson went as far as arguing QE is deflationary. His position later became the target of derisive criticism by more conservative economist Paul Krugman in an interchange of nasty blog posts.

In fairness the heated reaction is understandable as in my mind Williamson’s argument is confounding. Putting aside the technical aspect of his paper, Williamson’s states QE expands the amount of good collateral banks hold–short term treasuries and currency, and reduces the liquidity premium of riskier assets–MBS and long term treasuries. In order to induce banks to hold more good collateral, the rate of return on these assets must rise. With nominal rates at zero, higher rates of return must be obtained through falling inflation. Why prices fall is not explained any further.

The ineffectiveness of QE may better be explained through the disruptions in credit channels after the GFC. Banks may simply be unwilling to lend as household and business balance sheets are slow to recover. This is consistent with the view the US is currently in a liquidity trap; money demand is perfectly elastic as banks and households are hoarding cash and other liquid assets. Consequently the excess liquidity provided by QE may never enter the real economy through rising spending and investment.

Market Volatility

More recently, at a Fed board meeting, Janet Yellen and her team decided to further reduce the purchase of long term US treasuries and mortgage backed securities by a combined $10 billion. Consequently, equity markets in most major emerging economies has fallen steeply, whilst their currencies dropped heavily against the $US. In Argentina the peso fell by almost 30% as its central bank raised concerns about diminishing foreign reserves, undermining the partially pegged currency. Turkey’s central bank raised rates to 12% to combat high inflation and a falling lira. The decision to continue tapering has prompted massive capital outflow from emerging markets and back to the US, where yields are returning to more normal levels.

The severe market volatility caused by the tapering over the past month raises doubts about the merits of QE. During the Asia Financial Crisis of the ‘90s, banking sectors in many South-East Asian countries such as Thailand and Korea collapsed as they revealed a toxic pile of bad debt. The trigger was a hammering in domestic currencies which made it impossible for many Asian banks to finance their own short term borrowing denominated in $US.  The current fall in EM currencies may again expose dangerous balance sheet vulnerabilities within Asian banks. In China, the tightening of liquidity may encourage further imprudent lending from its shadow banking system, and subsequently threaten its sustained growth. The RBA’s recent Statement of Monetary Policy revealed local government non-bank financing, in addition to formal lending, had risen to 33% of GDP[3] in 2013. Even so, it is difficult to draw parallels between the Asian financial crisis and the current situation in Asia. Only time can reveal whether bad debt in China and other emerging markets spurred by QE is a pernicious threat or merely innocuous.

Central banking in a crisis

Perhaps the greatest defence of Bernanke’s untested policies comes from the Fed’s success in helping thwart a major financial collapse during the GFC. The Fed’s decision to buy mortgage backed securities provided much needed liquidity, at a time investment banks and other financial institutions found them impossible to sell. By repairing US banks balance sheets, the flow of credit between banks and to private individuals undoubtedly improved quicker than if left to its own devices. This is in stark contrast with the ECB’s lack of success in improving the condition of banks and lending in the E.U.  By learning from the mistakes of the Great Depression, the Fed’s intervention during the GFC likely avoided a much harsher recession.

The success of the Fed’s policies in more recent years, mainly scaling up QE, is less clear. The slow recovery in growth and employment up until the second half of 2013 is evidence of the diminishing returns of QE over time. Even if QE is viewed as a failure or success, the pace of the US recovery should not undermine Bernanke’s legacy. As chairman of the Fed during one of the most troubling economic periods in US history, Bernanke was bold when most would have been conservative. This is an achievement any leader should be proud to be remembered by.