Has quantitative easing worked? Lombard Odier’s Salman Ahmed comments
With tapering expectations in play recently, there has been a sharp increase in vocal criticism by many high profile investors of the US Federal Reserve’s QE policies, Salman Ahmed, global sovereign fixed income & FX strategist at Lombard Odier Investment Managers says.
The “peso problem” and QE
Deep uncertainty in the economic environment can lead to the “peso problem”. This is when the credible risk of a total system collapse can cause secular damage to long-term productivity growth and can, in turn, worsen the downward economic cycle.
We think that Bernanke’s doctrine of supporting nominal aggregate demand via printing money in the aftermath of the Great Recession has mainly been about circumventing the incidence of the “peso problem”, which could have led to a 1930s-style great depression.
Put another way, the Fed’s money printing exercise didn’t alter the real fundamentals of the economy, but influenced future expectations positively which increased the likelihood of a positive productivity shock taking place. This observation holds on the back of our view that the probability of generating a positive productivity shock is positively correlated with short-term nominal GDP growth and inversely to its volatility.
Here, the case of shale gas is an interesting example. It is plausible that this positive productivity shock, which can help the US achieve energy independence in coming years, wouldn’t have happened, if the economy hadn’t stabilized in 2009.
Inflation expectations have remained anchored
A key risk factor associated with pursuing QE policies is that of generating inflationary pressures. Policy-induced price pressures can in turn undermine central bank credibility, thus hampering the transmission of monetary policy. On this metric, so far, there is little scope for criticism, as both inflation and inflation expectations in the US have remained broadly stable since QE was deployed five years ago. Here, it is important to appreciate the difference between broad money and the monetary base. QE policy expands the monetary base but it relies on the banking sector to multiply the base money and transmit it to the economy. The decline in velocity of money in the aftermath of the financial crisis is well-studied and has mainly been driven by secular pressures on the banking sector, which constrained its ability to lend to the real economy, despite excess liquidity.
However, the growth recovery has been weak
One metric on which there can be some criticism of QE is that despite the size and scope of the easing program, recovery from the financial crisis has been very weak by post-war standards. In the US, the economy is yet to grow at pre-crisis trend levels (around 3%) on a sustained basis and the labor market remains weak five years down the line. Here, critics argue that the economy needs structural changes to bring trend growth back to pre-crisis levels and monetary policy alone can’t fill the gap when it comes to affecting real economic outcomes.
We see merit in this argument, however, it must be noted that the economic situation would have been much worse if we had encountered the peso problem, which was avoided only by decisive accommodative policy action. Over the last three years, negative shocks emanating from Europe have played a strong role in suppressing US growth as it damaged the positive transmission effects of the various QE programs by raising uncertainty around the health of the global financial sector.
Not easy to fight an accommodative central bank
The main message from the last five years is that it is not easy to fight a central bank bent on providing stimulus via wealth effects, especially in an era of low money velocity. This is very different from fighting a central bank keeping a tight policy stance, as the resulting damage to growth can create sharp political pressures in the other direction (e.g. the UK in the 1990s).
In this regard, it is easy to understand why investors jumped on the bandwagon when the Bank of Japan shifted its policy stance. As such, currency depreciation is an outcome of QE, irrespective of policy success (in terms of impact on real economic outcomes).
In Japan’s case, we are skeptical about whether the policy will regenerate growth in world’s third largest economy. However, we are still not convinced that taking on the central bank makes sense at the moment, especially when the policy is new and political support behind it very strong.
Successful exit will show if QE actually worked
Turning to the Fed’s case, we believe that the easing side of the unconventional policy against a backdrop of firmly anchored inflation expectation supports the case for large-scale asset purchases. However, given the unprecedented nature of the monetary easing program, it remains to be seen how the exit will proceed from here with the US economy showing signs of sustained improvement. As our CIO Jan Straatman argued in a recent piece, there is still considerable uncertainty around the exact shape and timing of central bank exit policies and long-only fixed income investors are exposed.
Moreover, as noted above, history also shows that it is easier to question a central bank in tightening mode and this holds even more true in the current environment, when the central bank has been the price-setter (in the form of “unlimited” buying) of the risk-free asset.