Quantitative Easing and Inflation:The Long and Uncertain Road Ahead

Dr Robert S GayFebruary 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 credit-induced 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 short-term 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)bwhere 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%)

Dec 1981

Dec 1983

Dec 1985

Dec 1987

Dec 1989

Dec 1991

Dec 1993

Dec 1995

Dec 1997

Dec 1999

Dec 2001

Dec 2003

Dec 2005

Dec 2007

Dec 2009

Dec 2011

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

Figure 3: U.S. Output Gap and Core Inflation

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 US Stand in Inflation Cycle?

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

Jan

19

86

Jan

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88

Jan

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90

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92

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94

Jan

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96

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19

98

Jan

20

00

Jan

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02

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20

04

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20

06

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20

08

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20

10

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12

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14

Jan

20

16

Figure 1: Fed Funds Effective Rate

Actual High Projection Low Projection

Where Does the Fed Stand in Tightening Cycle?

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