Halting QE = Active Monetary Asphyxiation?

A Guest Post By Benjamin Cole

The recent historical and empirical record strongly suggests central bank quantitative easing (QE) works.

The Bank of Japan ran a QE program (the buying of assets, usually bonds, by a central bank) from 2002-2006, coincident with their only sustained economic expansion since 1992. And, of course, the Japan economy is growing again, concurrent to the BoJ’s moderately aggressive QE program, part of the Abenomics package.

BTW, famed Stanford economist John Taylor authored a paper in 2007 gushing about the success of the 2002-6 BoJ QE program—and such a QE program was heartily advocated by iconic economist Milton Friedman in 1998.

Also, the U.S. economy has grown in stutter step to the Federal Reserve’s stop-and-go QE programs as well, even as federal fiscal deficits contracted sharply.

The Riddle Reframed

The riddle is whether both the Japan and U.S. economies will slip into stagnation again without QE, as long as there is a global glut of capital holding down interest rates, and inflation is dead—or even if inflation is near 2 percent on the PCE deflator, the putative Fed target.

The riddle might even be reframed: When central banks do not conduct QE, are they actively engaged in monetary asphyxiation?

Capital Gluts

As posted recently in this space, consulting firm Bain & Co. has forecast chronic global tsunamis of capital for years ahead, pushing interest rates down.

What happens if a central bank targets a 1 percent to 2 percent rate of inflation, when money markets are flooded?

Of course, interest rates cannot drop below zero, even when they “should.” A 1 percent to 2 percent inflation target may result in a central bank that effectively asphyxiates the economy, with resultant interest rates in the same or lower ballpark—but rates not yet low enough to stimulate growth, nor dissuade savings.

The resulting weak aggregate demand neither sops up the excess capital, nor results in higher interest rates or inflation. Call it “perma-zero-lower-bound (ZLB)-stagnation”.

Is that not a picture of Japan through much of recent history, or of the U.S., of late?

Perma-QE?

With global capital markets glutted, and ZLB ever knocking on the door, perhaps central banks should regard QE as a permanent policy, or at least very long-term, thought of in years rather than months—and after all, the BoJ stuck with the 2002-2006 QE program for four years successfully, and the record suggests the BoJ simply should have kept QE going.

Interestingly enough, even University of Chicago scholar John Cochrane now says converting the national debt into excess bank reserves will not be inflationary, as long as interest is paid on those reserves. He even says the Fed can pay those reserves by printing up more reserves. Call that a “get-out-of-debt-jail-free” card, a welcome fillip for taxpayers.

A Brave New (Capital-Glutted) World

The Fed and other central banks have stepped into a new world order of chronic capital gluts and consequent low interest rates. The traditional central bank tool for stimulus—lower interest rates—is as useful as a firehose against a flood.

Oddly enough, one can wonder if central banks can even raise interest rates—with so much capital afloat, long-term rates may hardly budge. A determined central bank raising short-term rates higher and higher will, ironically, ultimately obtain lower interest rates—recessions and weak growth do not make interest rates go up. And as Milton Friedman famously noted, low interest rates are a sign of tight money. A central bank cannot tighten its way to higher rates in the long-term. In a capital-glutted world, a central bank  will only lower rates closer to zero.

QE may be the only real tool central banks have. (Supply-side tax cuts are a good idea too, but that is whole ‘nother universe).

Inflation Dead

Happily enough, the abundance of capital radically mitigates any bottlenecks or supply-side restrictions that may result in higher prices. Capital is attracted to any market in which prices surge. Indeed, it is folly for central banks to concern themselves with commodities inflation—without such inflation, new supplies of commodities cannot open up.

Consider the recent explosion of U.S. oil production in the wake of higher oil prices. Global oil markets are a study in grievous structural impediments, but higher prices have done what they always do (at least in free markets). In commodities markets, higher prices compel supply growth.

Going Forward

Rather than genuflect to the encrusted bromides and doctrines of yesteryear, central bankers today must consider what is at hand. Interest rates may be near ZLB for the duration, and the duration may run in decades.

Capital is cheap, abundant and hungry, and new businesses and supply will open up if there is demand.

The only monetary channel left to boost demand is QE. Weak aggregate demand has been the recurring bane of Western economies for the last 10 years or more, not too-high inflation.

Moreover, QE has no track record of leading to much-higher inflation, although it is associated with better economic growth. QE does have a side-benefit of reducing outstanding national debt, if directed toward government gilts.

Yet again, it appears a Market Monetarist approach—that is, targeting robust increases in nominal GDP—is the best policy for central banks. And QE is the best, and perhaps only tool to get there.