Friday, 14 October 2011

Overlooked effects of quantitative easing

Last week the Bank of England issued another £75bn of quantitative easing (QE) in addition to the £200bn in 2009. Quantitative easing essentially means buying government bonds with newly printed money to drive down long-term interest rates due to the inability to lower the interest rates in a conventional way. A central bank creates incentives for the bankers to loan money to businesses instead of buying treasury bonds as the yield on the bonds goes down. The central bank also buys bad assets from banks to clear their balance sheets and decrease their borrowing costs. The immediate effects are devaluation of the national currency, lower gilt yields and higher inflationary expectations. 

It appears that QE became a simple solution for politicians to try and quick fix the economy, while bearing no responsibility if it doesn't work. Central banks are pumping money into the economy at every sight of a growth slowdown. Their hope is that by buying government bonds and clearing banks’ bad assets they will decrease gilt yields and drive down long term interest rates in order to create incentives for banks to start lending. The immediate effect of such an expansionary monetary policy is the devaluation of the national currency and higher inflationary expectations. Decreasing long term interest rates isn't only dangerous for higher expected inflation, they can also lead to an asset price boom, just like the one recently experienced in the US and many European countries. 

The graph below specifies the relationship between annual changes in housing prices and the Fed key interest rate, where it shows an interesting negative correlation between housing price changes and interest rates. A decrease of the interest rate will trigger a rise in housing prices while an increase of the interest rate will move the housing prices downwards. This mechanism was straightforward even in the years preceding the 2008 recession but it certainly wasn't the only factor that led to a steep rise and in the end of 2005 to a rapid decline. The inverted relationship is nonetheless still rather obvious.

Source: Vukovic (2011) “Political Economy of the US Financial Crisis 2007 – 2009” Financial Theory and Practice 35(1).
Even if the inflation and asset price boom fears are sustained and somehow the central bank manages to restore recovery so that it can start increasing interest rates again and lowering inflation, there is no guarantee that another round of QE can start-up economic growth. The policymakers seek an immediate impact in order to ease the pressure from the voters concerning a bad state of the economy and avoid reducing investor confidence. When a central bank buys the Treasury bonds to decrease their yields this will decrease borrowing costs but it is not enough to encourage banks to start lending money to businesses. In theory an incentive to behave in such a way is evident, since the banks can earn higher returns from loans to businesses instead of buying safe Treasury bonds and since their bad assets are being ‘cleaned’ by the central bank. But the theory disregards the role of confidence, uncertainty and future expectations in the economy that will more than anything influence banks’ lending decisions and businesses’ hiring and investment decisions. 

The regulators and the Bank of England (or any central bank in the recovering economies) send mixed signals and opposite incentives to banks and businesses. On one hand, regulators seek to steer banks into buying safe investments (consisting mostly of US and German government bonds with low yields) and on the other hand expect them to increase lending to businesses and start up economic growth. If a bank if forced to increase its capital reserves and discouraged into risky investments a climate of uncertainty is created in the bank as it has no incentive to offer risky loans again due to fears of another recession and due to pressure from the regulators and policymakers. Lower borrowing costs to encourage lending will not yield the effect the policymakers are hoping for when regulatory policies are contradicting each other. 

Lending to businesses and the support for innovation is highly discouraged, especially to small and medium sized businesses who don’t have enough credibility for any bank to support them on lucrative projects and investments. In the environment of mixed signals sent by the central banks on one side and the regulators on the other, no wonder the banks and the economy are in a stand still. No bank is ready to start lending in an uncertain environment. While the entire business world is waiting to see how the Greek and euro zone issues are to be resolved, the recovery plans are not showing good results, economic growth is still not improving and there are rising threats of a double-dip recession, no investor is going to invest, no bank will be willing to take on higher risks and the businesses will still be out of money and not ready to start hiring. 

Quantitative easing will therefore, due to uncertainty, low confidence levels and mixed regulatory policies only result in higher inflation and a devalued currency, while any of its possible positive effects will be crowded out.

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