Aside from reflating equity markets just what is Quantitative Easing doing for the wider economy?

Over the last few years, central banks around the world have been aggressively loosening their monetary policy. At the peak of the financial crisis with the collapse of Lehman’s, the US Federal Reserve had no choice other than to cut interest rates dramatically. So aggressive in fact was the easing of liquidity, that from a rate above 5% the FED funds rate was cut to just 0.25% in less than a year. And there it has remained for 4 years now.

Similarly, here in the UK, the BOE also had no choice other than to play the game of “follow the leader” in cutting interest rates to 0.5%. Even the hawkish ECB reduced rates to generational lows although they are a little higher at present than the UK & US at 0.75% having effected one rate rise during the last 2 years – unlike the BoE and the Fed.

After observing the economic horror of what happened in Japan – an economy which entered a 20-year deflationary process and where the BoJ was more measured in its liquidity priming with incremental loosening and fiscal supply side packages being regularly unveiled – and all having little effect in halting the deflation that ravaged the country and sent the yen to all time highs in 2011 it seems the UK & US central bankers have been determined to avoid the same fate. Or have they?

Central bankers in the UK and the US in particular, believed in carrying out bold action as the best medicine for the GFC with the UK adopting a quantitative easing program that at present has extended to some £375 billion in an expansion of UK’s the money supply, whilst the US embarked upon 3 separate quantitative easing programs totaling just over $3 trillion and being invested in MBS and agency debt.

I suppose that one could almost say that with the US economy motoring on nicely now and the unemployment rate down from the peaks of 9.9%, that the FED is trying to extinguish a dying fire rather by throwing the fire truck at it instead of the water inside it! One question remains however: Is it working?

Well, many may say the unemployment rate is lower (which it is) than it was and that the economy is growing (reasonably well) but the big picture tells us that six years after the first problems appeared in the US housing market (2007) that certainly the British, almost all the European economies, and Japan are still largely struggling to grow. As Japan showed us this last 20 years – the key to resolving the problems may not actually be in the expansion of monetary policy at this stage of the cycle whilst ignoring the fiscal side or worse contracting it.

Japan, under the new Abe administration, and the BOJ under Kuroda’s management, is attempting to emulate “helicopter” Ben Bernanke’s QE programs but, with something of a turbo boost – a fast and furious expansion of the monetary base to finally drive inflation and growth higher after such a prolonged period of stagnation. After twenty years of deleveraging, it is reasoned by Japanese politicians that is time for the country to register some decent and self sustaining growth from a higher inflationary plane.

Before Kuroda took his seat at the BOJ, the monetary base in Japan was already larger than in the US and UK as a percentage of GDP – 12% compared with around 6% in the other two. At the peak of the financial crisis, the FED expanded its monetary base by 250%, the ECB by 57%, and the BOE by 335%. At that time, the Japanese already had a much larger monetary base – a legacy of the desperate and continuous attempt to trigger growth during the 90’s and noughties – all to no avail. Only a few weeks ago the Japanese central bank announced a massive plan to double its monetary base in less than two years – by far the most ambitious of all the central banks.

In order to expand the money supply and eventually, hopefully to lead businesses and households to utilise the “free” money at almost zero rates and so invest and spend it, the central bank expands the monetary base. It is through the economic concept of the “money multiplier” that the expansion of the central bank’s balance sheet is supposed to filter through into the wider economy. I say supposed as in the UK this has not been happening.

Banks do still however have to respect the statutory reserve requirement imposed by the central bank and retain typically around 10% of their deposits in cash – effectively this means that the bank retains $10 on a current account held at the central bank and lends out the balance $90 of its hoard to households and businesses. In so doing, the commercial banks are effectively converting the monetary base into money supply. By taking the inverse of the statutory reserve requirement we get the money multiplier, which in the above case would be 1/0.1 or 10.

During Shirakawa’s prior governance at the BoJ, the corresponding multipliers for the FED, BOE, BOJ, and ECB, were 16.0, 9.7, 4.8 and 3.8. If the money multiplier were effectively working, then the money supply would be 16x larger than the monetary base in the US, 9.7x larger in the UK, and so on. One measure of economic theory stated that the corresponding inflation levels in the US and UK economies should be 1600% and 970% respectively! Clearly that hasn’t the case, as there is a missing link between the monetary base and the money supply. The monetary mechanism is broken.

Households and businesses quite simply are not borrowing. Their debt pay down and cash hoarding is merely acting as a neutralizing force to the actions of the central banks, so great is the debt overhang from the last 30 years.

The GFC caught many companies and people between a rock and a hard place and they are not in a rush to put their recent precarious financial states at risk again. Many are still enduring tough austerity packages in order to deleverage. This is exactly what happened in Japan during those 20 long years. During that period, households and businesses became debt-averse. According to Richard Koo from Nomura research:

“The fact that businesses and households in these [UK, US, Europe] economies are responding to zero interest rates by saving money rather than borrowing and spending aggressively clearly suggests that lending — and hence the money supply —will not expand no matter how much base money the central bank supplies.”

Basically the missing link that is debt deleveraging is preventing monetary policy from working per standard economic theory, and no matter the speed at which the central banks throws money at the economy, the money multiplier may continue to be muted.

Central bankers are trying to expand the number and dimension of lending mechanisms but there is simply a lack of borrowers – Western economies en bloc are not in the mood for leveraging up again.

In a stark example of the ineffectiveness of QE, consider the following – the BOJ buys JGBs from the commercial banks which then simply end buying JGBs again due to a lack of lending opportunities/recipients. The only other option is to adopt an expansionary fiscal policy and during the 90’s when the Japanese did embark upon their periodic infrastructure build out programs the economy did respond, problem was it was sporadic.

What drove down the Japanese economy to a dormant state was the austerity measures which were adopted by Hashimoto after 1997 –  a type of fiscal cliff which the Obama administration has been fighting to avoid and a similar to the packages widely being applied in Southern Europe. It seems the politicians here are blind to the experience of the Japanese.

Returning to the Japan monetary “fireworks”, in their case, perhaps the ammunition they are now using will not turn out to be blanks. It may just be the case that the domestic population actually starts believing that inflation will pick up and so it becomes self-fulfilling. This is why the Nikkei is motoring and yen falling sharply.

The problem for the Japanese central bank however is that if lenders also believe this, they won’t lend at the near zero rates and JGBs may start dropping as yields need to rise. At that point, the banks may incur hefty losses. The BOJ would have a dilemma: to increase or to decrease the monetary base. If they increase it, they will prevent commercial banks from losing money in JGBs but, with inflation picking up, it doesn’t make sense to continue expanding base money at the risk of entering an inflationary spiral. If they put an end to money expansion, commercial banks will face hard times once again… Something of a conundrum for the Japanese policy makers eh?

It’s time for us to understand that super loose monetary policy is great in helping correct financial imbalances but it is a dangerous route to follow when ignoring the interaction with fiscal policy and indeed in a debt bubble bursting scenario like we are seeing today, may actually be largely ineffective in the wider economy and only serve to blow localised bubbles.

Take a look at our Fed Bubble blowing guide below for more info on this subject.