Transcript Quantitative Easing and Inflation: The Long and Uncertain Road

Quantitative Easing and Inflation:
The Long and Uncertain Road Ahead
Dr Robert S Gay
February 18, 2013
The Rationale for Quantitative Easing
• Deep recessions create deflationary conditions that undermine the
effectiveness of traditional monetary tools.
• Central banks are thwarted in simulating domestic demand because of the
zero bound on nominal interest rates and their limited ability to influence
long-term rates.
• Negative real policy rates are a pre-condition to mending bank balance
sheets and hence to their willingness to extend credit.
• Unconventional policies such as targeted asset purchases and central bank
guidance are meant to influence those long-term rates that directly affect
household and business spending.
• The downside is that asset purchases also create a huge pool of excess
reserves in the banking system that could serve as fuel for another creditinduced bubble economy and chronic inflation. Unwinding QE is critical.
• The other concern is that governments will not make tough decisions to
control budget deficits if their central banks buy too much sovereign debt,
thereby fostering a downward spiral of debt, deficits and inflation.
The Setting of a Financial Crisis
• Credit events trigger financial crisis that engulfs
banking system.
• Distress spreads to capital markets due to forced or
panic selling of liquid assets and counterparty
concerns. Commercial paper market implodes.
• Recession ensues; output falls well below potential.
• Persistent output gap leads to disinflation (within 1
year) and eventually deflation;
• Recessions caused by financial crises are deeper and
last longer than typical business cycles because balance
sheets are impaired or over-leveraged;
Crisis Management Versus QE
• Central bank may need to provide liquidity for
dysfunctional capital markets by buying shortterm instruments, especially commercial paper,
and by providing currency swaps for trade
partners.
• At this stage, central bank’s asset purchases are
crisis management rather than QE. The goal is to
be the counterparty and lender of last resort.
• At extreme, central bank lowers it policy rate,
which is the cost of funding for banks, to zero in
order to save banking system.
The Stepping Stones to Reflation
• Central bank creates excess reserves in banking system.
• Asset purchases greatly amplify excess reserves that could be converted
into loans.
• Impact of QE on long-term interest rates depends on the size (not flow) of
asset purchases relative to marketable securities outstanding.
• Eventually banks do extend credit (lag could be short or could take
decades as in Japan). Rollover of ‘zombie’ loans dilutes and postpones
stimulus as they do not finance new purchases.
• This phase is monetary policy’s weakest link. Expected sales (or incomes)
drive investment decisions not the cost of capital. Low interest rates may
facilitate refinancing of old expensive debt but in themselves do not
necessarily stimulate new spending.
• Here is where the lag between the wherewithal of credit creation (excess
reserves) and ‘money creation’ (i.e. actual spending) can become long and
uncertain.
The Steps to Reflation (cont)
• Growth in credit outstanding is a requisite precursor to
sustainable growth.
• Actual growth in real GCP must exceed its long term
potential in order to close the output gap of preceding
recession.
• It typically takes 5 years of credit growth in excess of 10%
annually to return output its potential level.
• By this time, central bank should have wound down asset
purchases and raised its policy rate to neutral; it need not
necessary to sell its portfolio of assets which it instead
could hold to maturity.
• Inflation begins to turn up about one-year after output
crosses potential.
Debt, Deficits and Inflation
• The nightmare scenario is that government fails to remediate its
budget deficits and economic growth is insufficient to dilute them.
• Deficits become increasingly unsustainable as debt levels rise.
• In late stage of imminent default, markets demand higher real
yields on government bonds, as they did for Greece, Spain etal.
• In effect, the government borrowing requirement becomes the
source of both money creation, spending and inflation as was the
case in Latin America in the 1980s and 1990s.
• The key to debt sustainability is wean the government from deficits
before real interest rates exceed potential growth.
Debt Sustainability – Tipping Point
Internal debt arithmetic: the condition for runaway growth in money supply
comes from government budget constraint
M + B = v + ib
(money growth + debt creation = primary deficit + nominal debt service)
So money growth is an increasing function of primary deficits and debt/GDP:
M = v + (r – g)b
where v = primary budget deficit,
r = real interest rate,
g = potential growth and
b = ratio of debt to GDP
Implication: Although the US is running huge primary deficits, current debt
levels are sustainable as long as real interest rates stay low relative to
potential GDP growth (2.5%)
Where Does US Stand in Inflation Cycle?
Figure 3: U.S. Output Gap and Core Inflation
6.0%
4.0%
4.0%
2.0%
2.0%
0.0%
0.0%
-2.0%
-2.0%
-4.0%
-4.0%
-6.0%
-6.0%
-8.0%
Core Inflation (lhs)
Proj Core Inflation High (lhs)
Proj Core Inflation Low (lhs)
Proj Output Gap High (rhs)
Output Gap (rhs)
Proj Output Gap Low (rhs)
Where Does the Fed Stand in Tightening Cycle?
Figure 1: Fed Funds Effective Rate
10.00
8.00
6.00
4.00
2.00
0.00
Actual
High Projection
Low Projection
Jan 2016
Jan 2014
Jan 2012
Jan 2010
Jan 2008
Jan 2006
Jan 2004
Jan 2002
Jan 2000
Jan 1998
Jan 1996
Jan 1994
Jan 1992
Jan 1990
Jan 1988
Jan 1986
-2.00
The Fed’s QE Exit Dilemma:
Interest Arbitrage Backlash, A Stylized Version
Federal Reserve balance sheet
Bank balance sheets
Assets
Liabilities
Assets
Liabilities
US Treasuries
bank reserves
deposits at Fed
equity
(i=2%)
($1.6tr@i=0.25%)
($1.6tr @ i=0.25%)
Mortgages
loans/mortgages
debt
(i=4%)
other capital
‘Profits’ from Fed portfolio ($3 trillion) now amount to about $100bn per year and are
returned to US Treasury. Fed plans to add more UST this year.
Upon exit:
• Fed ends purchases of UST; yield on its UST portfolio is frozen at 2%
• Fed funds rate paid to banks on their reserve at Fed rises to 3-4%
• If Fed raises funds rate before sells its UST holdings, the current positive arbitrage in
favor of the US Treasury becomes a negative arbitrage in favor of commercial banks.
• Subsidy to banks increases as might amount to $50-75bn per year (2% on say $2.5tr =
$50bn). Any subsidy to banks will be viewed harshly by public and could undermine
banks incentive to make loans and mortgages which is a key objective of the reserves.
• Subsidy to US Treasury shrinks as securities in Fed portfolio mature