HAMISH MCRAE: Federal Reserve’s war on quantitative easing

HAMISH MCRAE: Central bankers, led by the US Federal Reserve, are starting to see the point in replacing quantitative easing with quantitative tightening

The world’s central bankers, led by the US Federal Reserve, are beginning to come to their senses. Quantitative easing – that ugly term for creating and pumping more money into the economy – is to be replaced by quantitative tightening.

Instead of putting more money in, the Fed will start sucking it back out. So QT replaces QE, and it’s about time.

Last week, one of the Fed’s governors, Lael Brainard, said it could start trimming its balance sheet next month and would do so “quickly.” The shrinking balance sheet is another way of saying the Fed will start QT.

Change of direction: instead of putting more money in, the Fed will start sucking it out again – QT replaces QE

She also warned that interest rates could rise in increments of more than 0.25 percent. Both of those points were confirmed by minutes the next day, which also included a strong indication that rates would rise 0.5 percent in May.

This is really big stuff. That means QE policy is dead. What the Fed does will have a profound impact on policy here in the UK and Europe. On Thursday, Bank of England chief economist Huw Pill gave a speech in which he said QE may be the wrong way to tackle future market disruptions. And while what the European Central Bank will do remains a bit of a mystery, Goldman Sachs just issued a note saying it believes the ECB will hike interest rates much sooner than markets are expecting, maybe already in July.

This change of course has already started to move the bond markets.

What’s happening with bond yields seems a little mysterious to most of us, and they certainly attract far less attention than stock prices or even house prices.

But in the last six weeks there has been a sea change that has swept across the world. Ten-year US government bonds yielded just over 1.7 percent at the beginning of March. Now the rate is 2.7 percent. The figures for 10-year-old gilts were then 1.1 percent and now almost 1.8 percent.

The 10-year German bund was actually negative on March 1st – you paid money if you were stupid enough to lend it to the German government. Now they bring in 0.7 percent, far too little, but at least you get something back.

This is a return to common sense by the global central banking community. Perhaps the policy of ultra-low interest rates and QE was necessary after the 2008-09 bank crash, and perhaps another bout was justified in relieving the world of the pandemic’s disruption. But it went on for far too long.

With current inflation staying low, they figured they could keep pumping the money along easily, and it’s true that the cost of the policy wasn’t very apparent.

But common sense dictates that if you print industrial amounts of money, there is a real risk that it will eventually lead to massive inflation. It happened in the 1970s and it’s happened again.

Why did inflation take so long? I don’t think we really know yet, but we do know that the delays in the economy can be very long.

The analogy I like best is to imagine you are filling a bucket with water. You keep pouring water and all is well for a while. Then suddenly the bucket overflows and the kitchen floor is flooded. QE keeps the taps going. QT cleans up the mess.

The cleanup is just beginning and is expected to take several years. Eventually we will return to the normal relationship where interest rates are slightly higher than inflation for sound borrowers and quite a bit higher for risky borrowers. This shift will cause disruption. Businesses that have been kept alive because they have spare capital will struggle.

Highly indebted countries may need to devalue – I expect further eurozone tensions. People who are over-indebted have to cut down or sell assets.

But it won’t be like the 1970s with double digit interest rates because inflation hasn’t gotten into the economy yet. Fortunately, the labor market remains very strong.

So while central bankers are right to be scared, the fact that they are scared means the rest of us can relax a little. That was the verdict of the markets last week. Stock prices have been fairly solid, with most major stock markets now higher than before the Ukraine invasion.

It’s going to be a bumpy ride back to normal, but for my part I feel a sense of relief that we’ve started. Well done the Fed.


HAMISH MCRAE: Federal Reserve’s war on quantitative easing

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