We are at a crossroads for extraordinary monetary policy.
The Federal Reserve is pursuing its programme of quantitative tightening, draining money from the financial system at an accelerating rate this year as it reverses the quantitative easing that substantially boosted US money supply over the past decade.
Meanwhile, in Europe, the European Central Bank has also reduced its asset purchase programme (similar to QE in its aims) and intends to withdraw it completely later this year.
Much is misunderstood about the original purpose of QE, what impact it has had and, in turn, what impact its withdrawal is likely to have. These misperceptions exist right at the heart of our central banks, so the risk of a major policy error cannot be ignored.
The original purpose of QE, as defined by the Fed in January 2009, was to “push down interest rates”. In that regard it clearly failed, as the chart below demonstrates.
During every single period of QE, long-term interest rates rose, not declined. Over the entire period of extraordinary monetary policy, bond yields fell but this is a function of declining inflation and low growth in this period, rather than the policy itself.
So, why did bond yields rise during each period of QE? The answer is because, all else being equal, QE is inherently inflationary.
Under the policy, US broad money supply grew by about $3tn between 2007 and 2013 – a period during which the normal driver of money supply growth, bank lending, contributed almost nothing.
In the resolution phase of a financial crisis, money supply growth comes under intense pressure because the banks constrain the supply of loans. Although QE was launched with the stated aim of lowering interest rates, it in effect represented the central banks stepping in to offset a contraction in money supply, providing a cloak under which the banks could slowly fix their balance sheets.
Extraordinary monetary policy therefore expanded broad money supply and prevented a full-blown debt deflation (unlike in the Great Depression, when the policy response probably made the deflationary situation worse). From this perspective, QE has to be considered a success.
However, I am concerned central bankers and financial markets do not appreciate this counterfactual and, as a result, there is widespread complacency about the deflationary impact of the policy’s withdrawal. By implication, the Fed’s programme of QT will increasingly exert deflationary pressure on the US economy and beyond.
In Europe, ECB president Mario Draghi is under the impression that the “tail risks, risks of deflation, have disappeared”, which sounds like a dangerously complacent thing for a central banker to say at any time, let alone in the current environment.
Another factor that appears to be under-appreciated by policymakers is the relationship between money supply growth and nominal GDP growth. In the UK (which provides much better money supply data than other economies, but there is no reason to expect this relationship to be different anywhere else) the correlation is very strong (see chart).
QT represents a contraction of money supply in the US and, in Europe, policymakers’ stated intentions will weigh on money supply growth at a time when the European banking system remains too fragile to pick up the slack. If policy evolves in the direction that has been laid out, it will increasingly weigh on growth in these regions. We are already starting to see the impact of QT in US money supply data and in global liquidity conditions.
By ignoring the relationship between money supply and nominal GDP, there is an increasing risk that central bankers in the US and Europe will make a significant error by withdrawing extraordinary monetary policy too soon or too fast, with obvious consequences.
To end on a more upbeat note, there is one developed economy whose money supply growth outlook is not facing the impact of the withdrawal of extraordinary monetary policy.
The UK economy has sustained nominal broad money supply growth of around 5 per cent per annum recently. This, coupled with all the other positive trends in the UK economy we have been seeing is enough to suggest domestic growth can accelerate in the months ahead. That will come as a positive surprise to the gloomy consensus.
Neil Woodford is head of investment at Woodford Investment Management