What are the longer-term implications of quantitative easing?

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Central banks’ intentions may have been honourable, but the policy initiatives implemented since the financial crisis have resulted in the distortion of financial markets and the misallocation of capital, according to Peter Hensman, global strategist at Newton.

While policy intervention has had pockets of success through easing social pressures, by, for instance, maintaining levels of employment, the ultimate affects have been both distortive and misdirected.

We remain sceptical whether such policy initiatives will succeed in creating an enduring upswing, thus delivering the desired ‘escape velocity’ that many official commentators believe has been achieved via unconventional monetary policies. As in previous cycles, the prevalence of cheap debt is likely to have simply dragged demand from the future into the present.

The narrative offered by the central banks is that rising asset prices will create a virtuous cycle, instilling confidence. This has been especially notable since the launch of ‘QE3′, where the equity market advance has been heavily reliant on the re-rating of valuations with little contribution from earnings growth.

Yet, the policy responses thus far are likely to have had unintended consequences and led to the disruption of business models.
The recent case of Lufthansa is a good example; the company recently issued a profit warning as it has been hurt by intense competition from Middle Eastern carriers, as the ready availability of finance has encouraged rapid capacity expansion.

Equally, the high valuation of technology companies that have been propelled higher by the dash from cash is enabling businesses such as Uber, the taxi app, to raise more money and undermine the pricing power of taxi drivers

The US Federal Reserve (Fed) is beginning to recognise the risks inherent in allowing its balance sheet to expand ad infinitum and Janet Yellen, chair of the Fed, is already steering policy towards ‘forward guidance’ rather than balance-sheet expansion.

The balance sheets of the world’s central banks have ballooned to more than $20trn since 2007 (roughly half of this in the developing world) through intervention in local bond and foreign exchange markets[1].

Market participants have come round to the idea that the next rate cycle will unlikely see interest rates return to old norms. With debt burdens still high and the failure to achieve economic ‘escape velocity,’ the authorities look to other remedies that maintain interest rates at low levels.

In this scenario, not only are near zero (and even negative) official short-dated interest rates likely to continue as the public sector debt overhang remains, the prospect that central banks will ‘set’ the level for yields for instruments as long dated as 10 years should not be dismissed.

On 21 November 2002, Ben Bernanke, then governor of the Fed, said in a speech before the National Economists Club: “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).”

Were such action on yields to occur – and it is by no means certain – it would not be without precedent for the Fed at least. Between 1942 and 1951, the Fed maintained a fixed yield curve as the Fed focused, in particular, on helping the US Treasury to finance the Second World War.

The low yield minimised the Treasury’s borrowing costs as gross federal debt grew from 42 per cent of GDP in 1938 to a then all-time record of 122 per cent of GDP[2].

Although there is an absence of war time conditions, debt has risen to unprecedented levels for peacetime. In the US, public debt as a percentage of GDP is 83.7 per cent[3].

The failure of asset inflationary policies to create sustained growth in income and demand could inspire even more extraordinary policy choices. While there is a great deal of attention paid to the inflation and employment aspects of the Fed’s mandate, the final requirement is maintaining “moderate long-term interest rates”. Could it be that this latter aspect that once again becomes the dominant requirement?


[1] Making the most of borrowed time, Jaime Caruana, General Manager, Bank for International Settlements, Basel, 23 June 2013

[2] Federal Reserve Bank of Cleveland April 17 2014

[3] The Economist


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