What are the long-term consequences of the last several years of experimentation with unconventional monetary policy? The most important long-term impact of the experiment will be its influence on future policy makers’ beliefs about the desirability of such actions. I believe the aggressive use of quantitative easing (QE) in recent years will make a similar experiment less likely in the future, as we learn about its limited benefits and significant risks.
As the U.S., the U.K., the Eurozone and Japan approached the zero interest lower bound, their monetary authorities adopted unconventional approaches to expand liquidity further. QE1, QE2 and QE3 not only massively expanded the Fed’s balance sheet, they achieved that expansion through unprecedented Fed purchases of long-term government bonds and mortgage-backed securities (MBS). Unlike normal monetary policy, Fed purchases of long-term treasuries and MBS are a form of fiscal policy because those purchases incur risks of future loss if the securities fall in value.
“There is reason to believe that commercial real estate, farm land, stock prices, variable annuities and other risky assets have become overvalued (to varying degrees) and either have already suffered or soon will suffer price declines as easy money disappears.”
Did the Fed’s fiscal policies targeted to MBS and long-term treasury spreads influence economic activity? The main channel of influence that Fed policy makers emphasized in their advocacy of QE was its effect on the prices of the assets purchased, and the consequences of those asset price changes for the real economy.
A study by Marco Di Maggio of Columbia, and Amir Kermani and Christopher Palmer of UC-Berkeley, entitled “Unconventional Monetary Policy and the Allocation of Credit,” finds that the Fed’s targeted purchases of treasury bonds had no discernible effect on mortgage lending, although they do find that targeted MBS purchases by the Fed succeeded in expanding the supply of mortgages.
Those findings are consistent with evidence provided by several economists – including Carnegie-Mellon’s Allan Meltzer, Stanford’s Arvind Krishnamurthy and Yale’s Gary Gorton – suggesting that QE policies have had a negligible, or even negative effect, on real activity.
Scores of academic papers show that long periods of extremely easy monetary policy foment bubbles in asset markets. Long-lasting interest rate cuts not only reduce the “risk free” interest rate, they reduce credit spreads in bond markets, loan spreads, and even the “equity risk premium” (the return in excess of the risk free rate demanded by equity holders), and drive outflows of funds into emerging markets, as U.S. investors search for yield in the face of declining interest rates at home.
When monetary policy reverses, that causes a drop in risky asset prices and a reversal of international financial flows. There is reason to believe that commercial real estate, farm land, stock prices, variable annuities and other risky assets have become overvalued (to varying degrees) and either have already suffered or soon will suffer price declines as easy money disappears. The junk bond market’s recent decline and the capital outflows, stock market declines and exchange rate depreciations in many emerging markets may mark the beginning of a long-term unwinding of risky asset prices worldwide. At the moment, it remains unclear how severe the price declines will be, but empirical evidence of the financial fallout produced by the heavy reliance on QE and other expansionary monetary policies, both from 2002-2005 and since 2007, likely will add to the arguments against repeating such actions in the future.
Another risk is an acceleration of inflation. Many economists have been expressing concern since 2009 about the potential long-term inflationary consequences of a major expansion in the size of the Fed’s balance sheet, particularly if that expansion took the form of purchases of long-term treasuries and MBS. Eventually, the “money multiplier” will increase to a normal size as banks reduce excess reserve holdings and expand loans and deposits (a likely possibility over the next several years). At that time, to prevent an acceleration of inflation, the Fed should move aggressively to shrink its balance sheet.
But in a rising interest rate environment, massive sales of securities by the Fed would result in large capital losses, making the Fed insolvent (only realized losses are reflected in Fed accounts). The Fed would be recognized as contributing to the federal government deficit (in contrast to recent times, when its profits have contributed to the surplus).
The Fed may not want to suffer that political risk. Furthermore, any dumping of MBS would raise mortgage interest rates. That might help the future Fed achieve its inflation-fighting objectives, but it would also create severe political consequences (unconditional commitments to boosting homeownership are a rare example of bipartisan consensus in Congress).
In recognition of these economic and political realities, some time ago the Fed made clear that it does not intend to sell its MBS acquisitions during its tightening phase, but rather to hold them to maturity. As tightening becomes necessary, the Fed intends to employ policies of increasing the interest rate on reserves and expanding “reverse repurchases” (that is, repeatedly lending its bonds to others rather than selling them).
This piece originally appeared in Forbes
This piece originally appeared in Forbes