Wednesday, November 01, 2017

St. Louis Fed: Good Case for QE Being Detrimental

The Fed was supposed to start reducing its balance sheet in October (but did it?). As the exit from quantitative easing takes effect, there's uncertainty as to the results. The end of QE 1, 2 and 3 all saw financial market declines and drops in interest rates. Although the goal of QE was to lower rates, it actually raised interest rates. QE pushed investors out of bonds and into riskier assets such as stocks. It increased the "animal spirits." A reversal of QE should produce a larger negative result and a new low in bond yields, if the pattern holds.

That's assuming QE itself didn't harm the economy. It's possible that QE suppressed credit growth by taking high quality assets (U.S. Treasuries) out of the financial system. (Banks use treasuries as collateral for derivatives, USTs are the high octane fuel for ultra-leverage.) What isn't known is how large the effect might be. If it was significant, the reversal of quantitative easing will increase credit growth and interest rates. The Fed thinks it will hike interest rates to ward off exploding credit growth and high inflation, but it's exit from QE might be the very trigger that causes it. In which case, every hike of interest rates will increase inflation, and the Fed will chase its own tail back to double-digit inflation.

I don't think that scenario is very likely, the former scenario makes more sense given the weight of evidence. Still, the Fed itself isn't sure about what's going to happen. It doesn't even know if QE worked.
Evaluating the effects of monetary policy is difficult, even in the case of conventional interest rate policy. With unconventional monetary policy, the difficulty is magnified, as the economic theory can be lacking, and there is a small amount of data available for empirical evaluation. With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case that QE is actually detrimental.
Quantitative Easing: How Well Does This Tool Work?

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