Monetary policy: quantitative easing and the race to the bottom

Alexandra Gorewicz's picture

There's an old joke in economics that goes: "The questions never change, but the answers always do". The unconventional answers that central bankers have developed over time to solve the lack of inflation (or in some cases deflation) are Quantitative Easing (QE) and Zero/Negative Interest Rate Policy (ZIRP/NIRP). Exhibit 1 below shows the two page document on the Bank of England website that was used to explain QE to the masses. If you don't have anything nice to say, you shouldn't say anything at all…so no comment. In theory, QE was designed to boost asset prices and reduce interest rates as central banks “printed” money (it was actually created electronically) to buy assets (predominantly government bonds) from financial institutions and banks. Lower interest rates would lead to higher borrowing by people and businesses, which would use their borrowings to spend and invest. This, in turn, would create jobs and lead to economic growth.


Exhibit 1: BoE’s Explanation of QE


As we attempt to answer age-old questions by pouring over current financial market developments and real economic results, which are not the same thing despite associations made by less sophisticated investors, it is difficult to conclude that unconventional monetary policy (and QE specifically) has been successful over the long run. Asset prices have certainly gone up since the great financial crisis (GFC) of 2008. Those who had wealth and were invested in financial markets since the GFC generally became wealthier. However, real economic realizations (in terms of inflation, GDP, and wage growth among others) – which ultimately create new wealth – have either been non-existent, insignificant or unsustainable considering what QE was supposed to deliver. On the flip-side, how much worse would those results have been had central banks not backstopped the world? Yes central banks backstopped the world, not just the global banking system or financial markets. See Exhibit 2 for a brief history of unconventional monetary policy actions taken by the central banks of Japan, UK, U.S. and Europe. The potency of the policy that central banks are able to unleash should not be underestimated, even in the present day.


Exhibit 2: A Brief History of Unconventional Policy Actions in Japan, US, UK, and Europe

Source: Bank of Japan, Bank of England, U.S. Federal Reserve, and European Central Bank


For the better part of last year, central banking appeared to be a global game of chicken – a two player game theory model of conflict – where the two players were the U.S. Federal Reserve (Fed) and everyone else (i.e. all other central banks). The game had two possible outcomes:


  1. Good economic data would lead to a Fed hike which would lead to relent by everyone else.
  2. Bad economic data would lead to a Fed relent which would lead to additional easing by everyone else.

Outcome number one transpired as the Fed raised interest rates by 0.25% on December 16, 2015. While all other central banks relented for a short-period of time, the subsequent sell-off in risky assets had resulted in a thorough review of the sustainability of the so-called “good economic data” that the Fed used to justify its most recent actions. And so, we once again find ourselves asking when, not if, central banks will double-down on their QE experiments. Although to be fair at this point, it is more akin to tripling-down or quadrupling-down. I know I'm making up words, but they're making up whatever...anything goes these days! Additional accommodation (i.e. monetary policy easing) by central banks in Japan, Europe and perhaps even the U.S. in the not-so-distant future will work in that it will force investors to pile back into risky assets. However, we shouldn't ask "Will risky assets rally?” We know they will. We should ask "Will the rally lead to real, sustainable economic outcomes?” Sadly, we know the answer to this question too, and so did Albert Einstein: "The definition of insanity is doing the same thing over and over and expecting different results." By that definition, the Japanese are downright psychotic, while the rest of the developed world is lagging by about a decade with emerging signs of neurosis. If you're not convinced, just look at Exhibit 3, which compares the trajectory of 10-year interest rates in the U.S., UK, and Germany since the turn of the millennium (2000) to Japan's 10-year interest rate trajectory beginning a decade prior (1990). While they do not follow each other perfectly, they're pretty darn close.


Exhibit 3: 10Yr Japanese Bond Yields vs Decade Lag of 10Yr US, UK, and German Bond Yields

Source: Bloomberg


So the most important takeaway from the last decade of Japan's history is that interest rates, economic growth, wages, and inflation are going anywhere but up. I suppose central banking is no longer a game of chicken. It has become a race to the bottom and we are all catching up to Japan.


Submitted by Jim Durnin on

Hi, excellent, well written article.


1. Could you define this more? In regards to real economic realizations (in terms of inflation, GDP, and wage growth among others), I see tremendous employment growth in the U.S. and wage inflation is starting. GDP growth has slowed, as has exports, but look at the DXY. The U.S. is close to full employment.
2. Why did the FOMC raise rates if things weren't going that well? They are data dependent, so what data are they looking at to justify this decision?
3. I can't even speculate what would have happened if the Fed had not stepped in in 2008-2009 and afterwards, maybe a repeat of the 1930's? They must have done the right thing as Japan and Europe have followed? Agree or Disagree?


Alexandra Gorewicz's picture
Submitted by Alexandra Gorewicz on

Hi Jim,

Thank you for your questions.

1. Full employment addresses the number of jobs created which admittedly, have been significant since 2009. However, the concept of full employment says nothing of the quality of jobs. U.S. Fed Chairwoman Janet Yellen has admitted over the last two days that "job creation has been skewed toward lower-pay sectors". She has also stated that "compensation growth hasn't shown sustained pickup" and "if job market keeps improving, wage growth should rise". These are important clarifications because they suggest that wage inflation is more a hope than a realization from the Fed’s perspective. The Fed also admits that long-term unemployment, which refers to people that have been unemployed for a longer period of time (say over a year), is higher than they would like it to be. This is symptomatic of a mismatch between the workplace skills that are demanded by employers versus the skills that are available by would-be employees. The U.S., in fact, has many job openings at the moment that remain vacant because employers cannot find people with the necessary (mostly technical) skills.

The market's inflation expectations, beyond just wages, have also tumbled – which is worrying central bankers around the world. For example, by our calculations, the market's expectations for the length of time it will take inflation to reach the Fed's 2% inflation target has doubled since the beginning of December 2015 – just prior to the Fed's interest rate hike. The Fed, and other central banks, have repeatedly stated that they expect the drop in oil prices to have transitory effects on economic results because oil producers are hurt by low oil prices. But, oil consumers should benefit from more disposable income that may be spent elsewhere. Thus, the economic impact is "balanced". That has not actually happened as oil consumers have not increased their spending elsewhere despite extra savings at the pumps. To really highlight the impact of low oil prices, the ECB has stated that it is paying close attention and is in the process of reviewing the effects low oil prices have on inflation. The ECB's Chief Economist, Peter Praet, even wrote in January that the "effect of [falling oil prices] is not negligible or temporary".

2. The Fed looks at an array of data so I won't speculate as to why they raised interest rates, although strong jobs numbers undoubtedly played a key role in its decision. However, I would state that a central bank's ability to conduct monetary policy is largely premised on its ability to affect expectations that investors have about the future. By changing expectations about the future, the central bank affects not only current short-term interest rates, but also investors' expectations of where those short-term interest rates will be in the future (i.e. the term structure of interest rates). In order to affect investor’s expectations, a central bank must be credible. By setting the stage and repeatedly stating throughout the first three quarters of 2015 that it would be appropriate to raise short-term interest rates "at some point in 2015", it may be argued that the Fed pinned itself into a credibility corner. If it didn't hike by the end of 2015, its ability to conduct monetary policy in the future would have been seriously compromised.

3. I, too, can't speculate on whether inaction by the Fed in 2008/2009 would have led to a repeat of the 1930s. Funny that you asked that as I just finished reading an article that asked whether the Fed's actions in 2008 avoided a depression or just postponed one. I do not believe that the Fed would blindly continue to raise interest rates if signs of a recession, let alone a depression, emerge. In the absence of a fiscal policy response, the Fed had, in my opinion, no choice but to step in and act. Whether the actions they took were the correct ones is impossible to say.

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