The dangerous QE ‘addiction’ that is afflicting central banks
Its unrestrained use poses risks which are getting little attention
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Introduced as an emergency response to a severe fall in aggregate demand at the end of 2008 and the beginning of 2009, quantitative easing (QE) has since become the main policy tool of advanced-economy central banks. In principle, there is nothing wrong with this. Central banks have long bought and sold government bonds to influence money supply. But the enormous scale of purchases during 2020 and 2021, in circumstances where the case for a substantial monetary injection was far from clear, led to concerns about its impact on inflation.
Introduced as an emergency response to a severe fall in aggregate demand at the end of 2008 and the beginning of 2009, quantitative easing (QE) has since become the main policy tool of advanced-economy central banks. In principle, there is nothing wrong with this. Central banks have long bought and sold government bonds to influence money supply. But the enormous scale of purchases during 2020 and 2021, in circumstances where the case for a substantial monetary injection was far from clear, led to concerns about its impact on inflation.
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Inflation is what we now have: 5.4% in the US and 2.5% in the UK, with more to come. This acceleration of prices is more than central banks were expecting. They’ve begun to back-pedal on commitments to a strategy of ‘lower for longer’, made when low inflation was expected to continue almost indefinitely. That’s a start, but a deeper rethink of when and how to use QE is called for.
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The Economic Affairs Committee of the UK’s House of Lords, of which I’m a member, has just issued a report on the challenges of using large-scale bond purchases as an instrument of monetary policy. Its title pointedly asks: ‘Quantitative Easing: A Dangerous Addiction?’ Our answer is ‘yes’.
The report makes four main points.
Don’t get locked in: Despite expansionary monetary and fiscal policy, central banks appear to see inflation risks as transitory. Some components of its pickup, related to base effects, almost certainly will be, and growth rates of broad money are beginning to fall back from exceptionally high rates at the turn of the year. Yet, the lack of concern that has characterized central-bank statements—at least until recently—fuels the perception that policymakers are stuck with their ‘lower for longer’ mindset. This matters, because if policy falls behind the curve, the cost of tackling a rise in inflation will be higher than it would be under a forward-looking, pre-emptive approach.
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QE is not a cure-all: Central banks have seemed to assume that any adverse shock justifies another round of bond buying. QE has become a universal remedy for almost any macroeconomic setback. But only certain shocks merit a monetary-policy response. The explanations provided by central banks to justify the scale of QE in 2020 changed over the course of the year, and failed to distinguish between shocks that justified a monetary response and those that did not. Moreover, after a decade of slow growth, it is far from clear that a short-term monetary-policy instrument will continue to be effective in boosting spending and output.
QE poses risks for central-bank independence: The panel looked closely at the relationship between QE and public finances. QE has made it easier for governments to finance exceptionally large budget deficits in the extraordinary circumstances of covid. But when central banks reduce this support, will they come under pressure to help finance ongoing budget deficits or to keep short-term interest rates close to zero? It’s possible they will. Central banks today operate in a more difficult political environment than 20 years ago.
Have an exit plan: QE tends to be deployed in response to bad news, but is not reversed when bad news ends. As a result, the stock of bonds held by central banks ratchets up, expanding their balance sheets into the longer term. When central banks adopted inflation targeting in the 1990s, they saw clarity about their policy reaction functions—how policy would change in response to news—as crucial for their credibility. Today, policymakers are struggling to explain how or even whether QE will be unwound. They’re rightly concerned about triggering a sharp market reaction to signals that asset purchases will be tapered, but the longer confusion persists, the greater the possible damage. The Bank of England appears to have changed its mind on how tighter monetary policy will be sequenced. Apparently, the plan now is to reduce QE before interest rates are raised. Our report urges much greater clarity on QE.
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It’s to be hoped these points are taken on board. The stock of assets purchased under QE is enormous. It stands at 30% of gross domestic product in the US and 40% in Britain. In the past few days, responding to new inflation numbers, members of both the Federal Reserve’s Federal Open Market Committee and the Bank of England’s Monetary Policy Committee have said they are willing to reconsider the path of asset purchases. But exactly how these central banks will undertake this adjustment and announce it to investors is unclear.
Far from being a policy for all seasons— an appropriate response to any economic shock—QE is desirable only when monetary expansion is required. Now is not one of those times. The pace of QE needs to be dialled back over the coming months, and central banks should be helping investors plan accordingly.
Mervyn King is former governor of the Bank of England
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