As good news appears to be bad news for now and the hopes of imminent dovish QE3-gasms gets pushed off a week or two, we thought it useful to dig into the mysterious central bank go-to play in a little more detail. Morgan Stanley's European Economics Team asks and answers five of the most frequently discussed questions with regard quantitative easing. From whether QE has worked to inflation fears and concerns over policy normalization and what happens if the public lose confidence in central bank liabilities, we suspect these questions, rather dovishly answered by the MS team, will reappear sooner rather than later, and as they interestingly note, the deployment of central bank balance sheets is, in essence, a confidence trick.
Q1: QE hasn’t worked. Why do central banks keep doing it? A: QE has worked, although the effects are likely to be diminishing. In the absence of more effective tools, central banks view the risk/reward of QE as favourable.
But to answer the question properly – to understand why central banks keep doing QE – it is important to put oneself in monetary authorities’ shoes and perform the same cost-benefit calculations that they are doing. It turns out that in the absence of other – more potent – policy tools, large real effects of QE are not necessary to induce central banks to engage in (further) QE. Given the potentially very serious adverse effects of deflation and the fact that central banks themselves view upside risks to inflation stemming from QE as small and manageable, then even very modest effects of QE are sufficient to justify it. Put differently, from central banks’ point of view, the risk/reward of further QE remains very favourable, indeed compelling, in the current economic environment. When there are few low-cost tools available, and as long as QE can reasonably be expected to make a positive contribution – however modest – to keeping the economy away from the danger zone, monetary authorities are likely to continue deploying this tool
Q2: QE has raised risks of high inflation, thus increasing inflation uncertainty. Has this not undermined investment and growth rather than supporting it? A: QE is just as likely to have reduced inflation uncertainty: While the risks of higher inflation have gone up, at the same time the risks of deflation have gone down.
Q3: Won’t the large amount of excess reserves inhibit rate hikes and policy normalisation? A: No. Central banks should be able to establish sufficient control over the overnight market to be able to push overnight rates higher. This, in turn, should increase borrowing costs and tighten financial conditions.
Q4: Why then do you still see inflation risks from QE? A: We worry that: (i) central banks will err on the side of caution and exit too late; and (ii) when the economy improves, banks will increasingly lend out their excess reserves, which could lead to inflation pressures.
Q5: What happens when the public loses confidence in central bank liabilities? A: A run on the fiat money system
In response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy. They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks’ own liabilities.
This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities – i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else. A central bank will, of course, never default on its liabilities – they can, after all, create unlimited amounts of it. But the ‘safety’ property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value – its value in terms of goods and services. So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public’s confidence in the real value of such liabilities – and government liabilities more generally. The more such liabilities are created, the more we approach this point.
How would such a loss of confidence unfold? If the supply of central bank liabilities – call it ‘liquidity’ – exceeds the public’s liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation – inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value. We are probably very far from such an outcome – far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.