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Quantitative Easing Effects Will Go Off-Script From Textbook

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People are understandably worried about the lasting impact that quantitative easing has had on the economy, but there are also a lot of misconceptions. “It‘s hard to go through a work day in the markets without hearing someone proclaim that central banks are printing money through quantitative easing,” write Nomura Group analysts Anthony Morris, Swati Aggarwal and Gerald Rushton. “The implication is that the major central banks are today acting like old-school third-world governments, running the printing presses to pay their bills.”

Link between quantitative easing and broader money supply is unclear

The connection between the Fed’s accommodative monetary policy and broader measures of the money supply are indirect at best, and attempts to predict the effect of quantitative easing and similar policies in the past have failed. While the Fed can help banks increase their reserves, that doesn’t mean they will be eager to take on new loans. A round of quantitative easing by the Bank of Japan in the last decade shows just how ineffective these policies can be at increasing money supply or spurring inflation.

Quantitative Easing japan monetary base v inflation (1)

In general, monetary growth is only correlated with inflation once it crosses a certain point (around 4-5% according to the graph below), and the connection between the money supply and inflation in the US is extremely noisy if correlated at all.

inflation and excess money supply  growth (2)

link between M2 and CPI (3)

“Generations of economics textbooks presented a world where growth in the monetary base would trigger growth in M1, which would trigger growth in M2 and associated bank lending. But there are times when this does not hold,” write Morris, Aggarwal, and Rushton.

If quantitative easing didn’t go by the book, why should tapering?

Now that tapering appears to be around the corner, more people are starting to ask what will happen as all of the excess liquidity gets mopped up (to be sure, some people have been asking this question for quite a while). But if textbook economics can’t really tell us what will happen when you inject money into the system, it’s hard to have much faith in what it tells us will happen when all that money is taken back out.

Earlier this year, David Zervos, head of global fixed income at Jefferies, said that quantitative easing is “The greatest monetary policy experiment of our lifetime and I do not think that anyone is smart enough, me, any central banker up there … to handle this when we need to handle it. We have never done it before and it will be a messy process.”

Half a year later, there doesn’t seem to be much more clarity, and anyone who is overly confident in their models should probably be reminded: “At the risk of stating the obvious, monetary aggregates do NOT need to move in a consistent, linear fashion,” write Morris, Aggarwal, and Rushton.

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