Central Banks On The Edge Of A Cliff: Meet The Lemmings Of QE
By Stephen Roach
Predictably, the European Central Bank has joined the world’s other major monetary authorities in the greatest experiment in the history of central banking.
By now, the pattern is all too familiar. First, central banks take the conventional policy rate down to the dreaded “zero bound.” Facing continued economic weakness, but having run out of conventional tools, they then embrace the unconventional approach of quantitative easing (QE).
The theory behind this strategy is simple: Unable to cut the price of credit further, central banks shift their focus to expanding its quantity. The implicit argument is that this move from price to quantity adjustments is the functional equivalent of additional monetary-policy easing. Thus, even at the zero bound of nominal interest rates, it is argued, central banks still have weapons in their arsenal.
But are those weapons up to the task? For the ECB and the Bank of Japan, both of which are facing formidable downside risks to their economies and aggregate price levels, this is hardly an idle question. For the United States, where the ultimate consequences of QE remain to be seen, the answer is just as consequential.
QE’s impact hinges on the “three Ts” of monetary policy: transmission (the channels by which monetary policy affects the real economy); traction (the responsiveness of economies to policy actions); and time consistency (the unwavering credibility of the authorities’ promise to reach specified targets like full employment and price stability).
Notwithstanding financial markets’ celebration of QE, not to mention the Federal Reserve’s hearty self-congratulation, an analysis based on the three Ts should give the ECB pause.
In terms of transmission, the Fed has focused on the so-called wealth effect.
First, the balance-sheet expansion of some $3.6 trillion since late 2008 — which far exceeded the $2.5 trillion in nominal gross domestic product growth over the QE period — boosted asset markets. It was assumed that the improvement in investors’ portfolio performance — reflected in a more than threefold rise in the S&P 500 SPX, -1.40% from its crisis-induced low in March 2009 — would spur a burst of spending by increasingly wealthy consumers. The BOJ has used a similar justification for its own policy of quantitative and qualitative easing (QQE).
The ECB, however, will have a harder time making the case for wealth effects, largely because equity ownership by individuals (either direct or through their pension accounts) is far lower in Europe than in the U.S. or Japan. For Europe, monetary policy seems more likely to be transmitted through banks, as well as through the currency channel, as a weaker euro EURUSD, +1.17% — it has fallen some 15% against the dollar over the last year — boosts exports.
The real sticking point for QE relates to traction. The U.S., where consumption accounts for the bulk of the shortfall in the post-crisis recovery, is a case in point. In an environment of excess debt and inadequate savings, wealth effects have done very little to ameliorate the balance-sheet recession that clobbered U.S. households when the property and credit bubbles burst.