Sunday, September 30, 2018
No need to get queasy about the unwinding of QE
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

When America’s Federal Reserve raised interest rates on Wednesday, nobody was much surprised. The increase, the eighth since the US central bank began to move away from its crisis level of near zero interest rates, takes the official rate to a new target range of 2% to 2.25%.

That is still very low by past standards and, with luck there may not be many more rate rises to come. There will be another this year, in December, and maybe two or three next, but the Fed no longer regards monetary policy as “accommodative”, central banker language for stimulating the economy.

Alongside the Fed’s announcement was conformation that it will continue unwinding its quantitative easing (QE), by $50bn (£38bn) a month from October. It brought barely a murmur.

QE remains one of the most controversial policies embarked on by central banks to pull their economies back from the brink and avoid a re-run of the Great Depression of the 1930s. The Fed is close to the 10th anniversary of its launch of QE, while for the Bank of England it began a decade ago next March, alongside a reduction in official interest rates to what was then an all-time low.

Since then, the Fed, European Central Bank, Bank of England, Bank of Japan and others have done around $14 trillion (£10.7 trillion) of QE, of which £435bn has come in Britain from the Bank. $14 trillion is a big number; if you want to put it in perspective it is nearly a fifth of the combined gross domestic product of every country in the world.

From its launch, QE has been widely misunderstood. Many thought it was all about bailing out the banks, which it was not. Other predicted a great inflation, even a hyper-inflation, as central banks turned on the monetary taps, and were embarrassingly wrong.

Once people saw how easy it was for central banks to electronically create money and purchase assets – the Bank’s QE vehicle is known as the asset purchase facility – eyes began to light up. Why not electronically create money to build roads, bridges, houses, hospitals or schools, or give every household a big cash bonus?

Those arguments, misguided as they were, have not gone away. Some are still determined to see QE as a magic money tree. There are other arguments about QE, which is the policy has benefited the holders of assets, and thus increased inequality. But an asset purchase programme was always going to benefit the holders of assets, mainly pension funds and insurance companies, and any marginal increase in wealth inequality looks like a small price to pay for avoiding more serious economic damage and deflation.

What we are now seeing in America, and will see at some stage in Britain, is one of the essential components of QE, its reversibility. The assets, mainly government bonds, that were purchased, can be sold back. That is what kept the policy honest, and anchored, as distinct from a Weimar Republic, or Zimbabwe-style exercise in money-printing.

At first, as in America, the process of running off QE assets is being achieved by not reinvesting the proceeds of maturing bonds. Later, if all goes well, central banks will step it up by actively selling bonds back into the markets.

The interesting thing, so far at least, is the dog that has not barked. Markets were supposed to fear the indigestion, and the loss of a comforting balm, that the reversal of QE was supposed to bring. Five years ago even the prospect that the Fed was about to wind down the amount of QE it was still doing produced the so-called “taper tantrum” and markets, like spoilt children, took a long time to get over their sulk. Now they are very relaxed.

It this the shape of things to come? Gertjan Vlieghe, a member of the Bank’s monetary policy committee since 2015, has worked in both the Bank, as economic assistant to Mervyn King, and in the markets, for J P Morgan, Deutsche Bank and Brevan Howard. He is thus well placed to assess the impact of the unwinding of QE on the markets and the economy.

In a speech at Imperial College in London Vlieghe addressed the issue. His starting point was something else QE often gets blamed for, flattening the yield curve. Normally, in the 20th century, holders of long-term bonds required significantly higher returns than holders of short-term bonds. The yield curve was upward sloping and higher yields on long bonds supported, among other things, more generous annuity rates on pensions.

Vlieghe point out, however, that a flatter yield curve was typical in the era of the gold standard in the 19th century, that its upward slop largely reflected the return of inflation in the second half of the 20th century, and that the period of Bank independence since 1997 has been associated with more stable inflation – and a lower risk of high inflation – than before. The conditions were in place for a flatter yield curve long before QE came along. There is more in the speech that elaborates on this point, and on his view about how QE works, but I don’t want to get too bogged down.

This then leads on to his second conclusion, that the fear in markets that a reversal of QE is bound to put up long-term interest rates and steepen the yield curve, is misplaced.

That does not mean unwinding QE will have no effect. When any stimulus is withdrawn, the effects of that stimulus in boosting the economy will fade. Central banks, by raising interest rates alongside the gradual unwinding of QE will be taking their foot off the monetary accelerator and, in time, pressing down gently on the brake.

There is no need, however, for that process to be disruptive. As Vlieghe puts it: “Unwinding QE need not have a material impact on the shape of the yield curve, or indeed on the economy, if properly communicated and done gradually.”

We are still, of course, some way away from the unwinding of the Bank’s £435bn of QE. It will not happen until interest rates reach 1.5%, and they are currently only half that level. It remains possible that, in the event of a rocky, no-deal Brexit, the Bank will think it is obliged to launch a further tranche of QE.

But it will eventually be reversed. And there is no reason why we should be unduly worried about that.