Strategy & economics

Full-fat monetary policy

22/01/2014

Richard Jeffrey

Richard Jeffrey

Chief Economist

It seems very likely that when, in a year’s time, I am writing about economic prospects, one of the subjects moving into focus will be the timing of an increase in interest rates. That is not to say that the future of monetary policy is not being debated now. But the intention of guidance from central banks is to reassure markets that policy will not be tightened any time soon. To be sure, the Fed has begun tapering its quantitative easing (QE) – but this is not tightening; it is simply and very gradually reducing the rate at which additional liquidity is being pushed into the financial system.

QE is nothing short of the biggest policy experiment that we have seen in our lifetimes. To date, its most obvious impact has been on asset prices, particularly those of government bonds, but also of commodities. Central banks would have us believe that QE has also had a strong positive impact on real growth. This is easier to claim than to detect. Nor does it seem to have had a significant impact on consumer prices (despite stated objectives), since in most western economies, inflation is falling.

In the immediate aftermath of the financial crisis, it was vital that central banks took steps to ensure that a banking meltdown was not caused by lack of liquidity. QE provided that liquidity. In the UK, the Bank of England (BoE) could have been much cleverer, buying lower-quality corporate debt rather than high-quality gilts, but at the time this seemed to be too much of a stretch of the imagination for the Monetary Policy Committee. Initially, QE was pursued more aggressively by the BoE than by the Fed, but it was brought to a close earlier. Eventually, once it has ended in the US, the amount of QE undertaken by the Fed will be similar to that sanctioned by the UK monetary authorities.

Almost by definition, central bankers exude confidence and foster an air of infallibility. They would say that this is vital if they are to maintain market confidence in policy. It is all too obvious, however, that our central bankers are far from being infallible. It is not just the fault of those in commercial banking that the world’s banking system almost collapsed. So, how confident should we be that QE will not cause unforeseen and damaging aftershocks?

At the very least, QE has, as noted above, caused severe distortions in asset prices. At the same time, it is probably also the case that QE has delayed the mending process within the wider monetary system. But the biggest question relates to the longer-term impact on the price level. One often-used analogy is that QE has been akin to putting the economy on a highly addictive painkiller. So, tapering is akin to gradually weaning the economy off that drug. In my view, this is not the right analogy. Sure, it suggests the dependence that QE creates, but it also suggests that tapering will reduce and eventually remove the addiction – and also remove the drug from the system. This is far from being the case. A better analogy would be force feeding someone with an abnormally-high carbohydrate diet. During the period of intake, the person will build up significant amounts of fat – partly visible, but also around vital internal organs. Once the diet has ended, the person might seem to shed some weight, but the fat within the body remains dangerous and in the wrong circumstances can have severe consequences.

This analogy is by no means perfect, but the point it emphasises is that if QE is not to cause secondary damage to the economy, most likely in the form of higher inflation, then it must be worked off gently over a relatively long period. This is not just tapering, but actually beginning to withdraw some of the stock of liquidity that has been added.

If this does not happen, then eventually monetary authorities will likely be forced to be more aggressive with their use of interest rates, in order to stop faster growth leading to accelerating consumer prices. My concern on this front is all the greater, since the prevailing central bank dogma seems to be that it is better to be behind the policy curve than in front of it. Given the lags in the system, this simply increases the probability that the fallibility of our monetary institutions and policy makers will again become all too obvious.

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