The Fed fesses up: QE didn’t work

In November 2008, the US Federal Reserve, while cutting the benchmark Fed Funds Rate aggressively, embarked on a large-scale programme of purchasing mortgage-backed securities (MBS) and US Treasuries for freshly conjured up electronic money. The purchases, dubbed Quantitative Easing, was the first of three such operations that took the Fed’s balance sheet from less than $1trn to the current level of around $4.5trn – equivalent to 24% of US GDP. Last week, Fed Chair Janet Yellen announced the intention to reverse the programme (quantitative tightening, or QT). There is no intention to sell assets, but rather of halting the reinvestment of proceeds from maturing securities. Starting at a modest $10bn a month, the goal is to eventually reduce the balance sheet by $50bn a month until an as yet undecided desired balance sheet size is reached.

The effect of QE has been the subject of much debate. The mechanics of the operations have been for the Fed to purchase Treasuries and MBS from commercial banks in exchange for new bank reserves, thereby freeing up money for lending activities, increasing the money supply and suppressing interest rates. Though not directly financing government deficits (that would be the case if QE was never unwound), the large-scale purchases have facilitated cheap government borrowing at a time when deficits have reached record levels. And new money has found its way into equity markets, where valuations are at record highs.

We on this blog have repeatedly argued that real wealth has to be produced, not printed in the Fed headquarters in the Eccles Building, and that QE has only served to inflate asset prices. It seems the Fed has now reached a similar conclusion. Stephen Williamson, an economist at the St. Louis Fed, recent published a report assessing the policy: ‘Evaluating the effects of monetary policy is difficult, even in the case of conventional interest rate policy. With respect to QE, there are good reasons to be sceptical that it works as advertised, and some economists have made a good case that QE is actually detrimental.’ Williamson compared outcomes in the US with Japan and Canada, where central banks have also held their benchmark rates near zero. Canada, however, did not pursue a QE programme: ‘there is little difference from 2007 to the fourth quarter of 2016 in real GDP performance in the two countries’.

Williamson concludes that ‘there appears to be no evidence that QE works to increase inflation’, and consumer prices have indeed remained relatively stable. But as we have argued, that does not mean that QE has had no effect on prices, some of which have of course risen dramatically – but not in supermarkets; in financial markets. And creating a wealth effect was indeed a stated aim of QE. Now, the announced tightening is unlikely to unfold without comparable adverse effects on asset prices. The question is, what will be the response when financial market valuations drop? Will the Fed assume responsibility for keeping asset valuations up or stand by, presumably ready to push the blame onto the Trump administration? If they act, it is the intention for the announced QT operations to continue unabated; policy rates, which have been edging up, will be the first line of response. But a steep drop in equity markets and any sense of panic could soon see a reversal of QT, or even further QE.

So far, the Fed has managed to spin a story of disaster averted and job well done, despite their recent admission that there is no evidence of any positive effects of QE. To many Americans however, working several part time jobs for stagnating wages, the proclaimed recovery of course remains elusive.

QE has a lot to answer for. By suppressing interest rates, it has allowed government to access cheap financing and avoid pressures for fiscal discipline. Inflating asset prices has benefited the asset rich, widening the gap between the very wealthy and the 99%, which, while seen by the naïve as a failure of capitalism, can be directly linked to the resurgence of long discredited socialist ideas. With the Fed admitting that the effects outside financial valuations remain elusive, QE should now be a discredited idea. But Janet Yellen is unlikely to stand by should a stock market crash threaten financial stability, or should a rise in Treasuries yields threaten the sustainability of ever increasing government debt. Sadly, despite the evident failure of QE, we may not have seen the last of it.

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