Conservative QE and the zero bound.

It has been a while since we talked about QE, but we covered this substantially in the past (see for example ‘Sub Zero?’,  ‘QE – quite extraordinary‘ and ‘Quantitative easing – walking on custard‘). It now appears, at least for the time being, to be a part of monetary history in the UK, and more recently the US. However, it is being reapplied in Japan and about to do a grand tour of Europe. Our earlier blogs were an attempt to analyse a new experiment. What do we think now we have had the practical implication of the theory?

Let’s go back to basics first. Monetary policy reaches the zero bound, so short term interest rates can no longer be cut. Therefore it is time to print money. Being prudent, the central bank needs to be able to tighten policy again at some point by destroying the printed money. So it favours purchasing large, liquid, risk free debt and buys government bonds in huge quantities.

This drives longer term interest rates down to the zero bound, and therefore should encourage long term borrowing, discourage long term saving, increase asset prices that are a function of long term rates (property and equity), and therefore via the wealth effect, stimulate growth.

The above effects and especially the wealth effect are seen as proof by its supporters that QE has worked via higher asset prices and this chart is often used as evidence of the correlation between the two.

UK QE and asset prices

Asset prices have risen and growth has indeed returned, but where is the inflation?

Inflation has indeed been temporarily induced in countries where the exchange rate has collapsed (for example the UK and Japan). However, this has proved to be a blip in the UK, and will likely be the same in Japan once the yen, which is down more than 50 percent versus the dollar over the past three years, finds a new stable equilibrium.

There are principally two reasons inflation has not returned. Firstly, inflation is not just a monetary creation but is a function of other factors, ranging from the oil price, to productivity, technology, inflationary expectations and free markets. The first of these has been exceptionally volatile, creating cyclical inflation and disinflation spurts, whilst the last four have been a constant driver of structurally low inflation for many years.

Secondly, let’s look at what QE actually does from a monetary perspective. The central bank simply exchanges cash for near cash. Holders of government bonds now own cash having sold them, while the central bank now owns government bonds. Interest rates are lower along the yield curve, but there is no actual new money circulating in the economy. Cash that has been created has been exchanged for another form of cash – government bonds.

Central banks have printed money in a very conservative way, so its growth and inflation effects are limited to wealth effects, and a reduction in long term rates.

The interest rate effect of driving the whole yield curve towards zero will reach its own zero bound, and cease to be effective, like short rates at the zero bound. The wealth effect will diminish as it will reach the bounds of investors’ rational market expectations (like inflation expectations) and asset prices will cease to rise as strongly. The assets that do rise are held by individuals who will reduce their marginal consumption as their wealth increases, or those that can’t access them as they, for example, are in a pension fund. Therefore QE itself, in its current form, reaches a zero bound.

When we first discussed QE, the great fear was that it would result in an inflationary spiral as money is printed prolifically. However, QE has been done in a responsible fashion so far. If it were to return to its philosophical roots, as outlined by ‘helicopter Ben’ in his 2002 speech before the National Economists Club, then you would get inflation. Printing money with nothing in exchange for it is inflationary. Printing money and swapping it for near money (ie government debt) is not quite the same.

Fortunately, monetary and fiscal policy has been effective in restoring growth, though inflation remains low. Will the new member of the QE fan club that is the ECB generate any meaningful long term inflation with its traditional QE programme? I doubt it. No one else has.


Discuss Article

  1. Alan Duff says:

    Thank you for another very interesting update. I have two queries:

    1. Do you think the recent fall in the oil price has been sufficiently priced into inflation expectations? We have done some work on the relationship between the oil price and inflation but we have not yet convinced ourselves there is a direct correlation. Having said that, the magnitude of the fall in the oil price in Q4 is such that I would expect it to have a tangible impact on inflation and may even result in a deflation scare next year. This leads me on to my second query.

    2. How strong do you consider the zero ‘bound’ to be? Some Swiss Government bonds are already yielding less than zero and, in times of distress, other Government bonds have yielded less than zero too. In a deflationary environment, buying a bond with a negative yield could still be a rational choice (and that’s before any further pension fund de-risking) and investors may prefer to lose a small amount with certainty rather than invest in a risky asset. In a world of negative rates one could argue that a UK 10-year Gilt yielding +1.9% looks incredibly cheap?!!

    Posted on: 10/12/14 | 12:39 pm
    • Gordon Harding says:

      Thanks very much for your comments and I’m glad you liked Richard’s post. Assuming investors are rational then you could argue that the fall in the oil price is priced in to expectations. The sharp fall in 5 year US breakevens from 2.1% at the end of June to 1.3% today would certainly suggest a lot has been discounted. Obviously looking further than the short term the difficult question is where the oil price goes from here. Regarding the relationship between oil and inflation – we were sent this chart from @Berenberg_Econ you may find interesting, suggesting 1.2 percentage points could be subtracted from EZ inflation by early next year.

      See chart

      In terms of official rates, the zero bound is likely to be quite strong as Peter Praet (ECB chief economist) mentioned this week when he said the ECB would probably have cut rates if they weren’t already at zero. As you point out though, bond yields can be negative (bunds are negative out to about 4 years) but remain close to zero. On the face of it, relative to bunds, 10 year gilts look close to the cheapest they have been since the late 90’s

      Posted on: 12/12/14 | 1:05 pm
      • Alan Duff says:

        Thank you for your response and for the chart. Really useful.

        Posted on: 16/12/14 | 11:00 am
  2. john slater says:

    If this is the case then doesn’t this mean that long term rates will stay low for years as there is nothing on the horizon to drive up inflation?

    Posted on: 10/12/14 | 6:04 pm
  3. Nick says:

    We did have hyperinflation during QE but BoE CPI’s is unable to measure it.

    -An Essentials index showed that inflation during 2010-2011-2012-2013 peaked at 8%.

    -ONS stats for low income inflation showed that this is higher than CPI for lower incomes in the last years. Thus the 5.2% peak of the CPI translates to 6.2% for lower incomes in UK

    -Since House prices are not in CPI, then it does not reflect reality.

    So QE caused hyperinflation.

    Posted on: 11/02/15 | 9:57 am

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