Quantitative Easing

HAMISH MCRAE: The US Federal Reserve at war with quantitative easing

HAMISH MCRAE: Central bankers, led by the US Federal Reserve, are beginning to see the meaning of quantitative easing to be replaced by quantitative tightening

The world’s central bankers, led by the US Federal Reserve, are beginning to get it. Quantitative easing – that ugly phrase for creating more money and pumping it into the economy – needs to be replaced with quantitative tightening.

Instead of putting more money in, the Fed will start taking it out. So QT replaces QE, and so does time.

Last week, one of the Fed’s governors, Lael Brainard, said it could start shrinking its balance sheet next month and would do so “at a rapid pace”. Shrinking the balance sheet is another way of saying the Fed is going to start QT.

Change of direction: instead of investing more money, the Fed will start sucking it up – so QT replaces QE

She also warned that interest rates could rise in increments of more than 0.25%. Both of these points were confirmed by the next day’s minutes, which also suggested that rates would rise by 0.5% in May.

It’s really big. This means that the QE policy is dead. What the Fed does will have a profound influence on policy here in the UK and in Europe. On Thursday, Huw Pill, chief economist at the Bank of England, gave a speech in which he said QE could be the wrong way to tackle future market disruptions. And while everything the European Central Bank will do remains a bit of a mystery, Goldman Sachs just released a note saying it thinks the ECB will start raising interest rates much sooner than markets expected, perhaps. be as early as July.

This change in policy has already started to move the bond markets.

For most of us, what happens to bond yields seems a bit of a mystery, and they certainly get a lot less attention than stock prices or even house prices.

But in the last six weeks there has been a sea change that has swept the world. In early March, ten-year US Treasuries were yielding just over 1.7%. Now the rate is 2.7%. The figures for ten-year gilts were then 1.1% and now close to 1.8%.

As for ten-year German bonds, they were actually negative on March 1 – you paid money, if you were crazy enough to do so, to lend to the German government. Now they return 0.7%, way too low, 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 needed after the banking crash of 2008-09, and perhaps another fight was warranted to ease the world through the disruption of the pandemic. . But it took too long.

Because current inflation remained low, they thought they could continue to pump in money without any problems, and it was true that the costs of the policy were not very obvious.

But common sense says that if you print industrial quantities of money, there is a huge danger that it will eventually lead to massive inflation. It happened in the 1970s and it has happened again.

Why has inflation taken so long to show up? I don’t think we really know yet, but we do know that delays in economics can be very long.

My favorite analogy is to imagine that you are filling a bucket with water. You keep pouring water and everything is fine for a while. Then suddenly the bucket overflows and the kitchen floor is flooded. QE keeps the faucets open. QT fixes the mess.

This cleanup is just beginning and will likely take several years. Eventually, we will return to the normal relationship where interest rates are a little higher than inflation for strong borrowers and much higher for riskier ones. This change will cause disruption. Businesses that have been kept alive because they have free capital will struggle.

Heavily indebted countries may have to devalue – I expect a new episode of tensions in the eurozone. People who have borrowed too much will have to reduce or sell assets.

But it won’t be like the 1970s with double-digit interest rates because so far inflation has not been allowed to creep into the economy. Fortunately, the job market remains very solid.

So while the central bankers are right to be scared, the fact that they are scared means the rest of us can relax a bit. This was the verdict of the markets last week. Stock prices were quite strong, with most major stock markets higher now than before the invasion of Ukraine.

It will be a bumpy old ride back to normality, but for me, I feel a sense of relief that we have begun. Well done, the Fed.