The long unwinding road of quantitative easing

Quantitative easing (QE) has resulted in heavily indebted developed economies and has had varying degrees of success.

An unwinding of QE could cause increased volatility in the markets and a fight for remaining liquidity, as the supply of government bonds starts to disappear.

QE has served its purpose of being a life raft for many of the largest economies and now central banks must start to go back towards the norm of pre-crisis levels, so that they have ammunition to tackle the inevitable next crisis.

The reasons for using QE and its effectiveness have been argued at length and this article aims not to discuss whether or not QE has worked, but to look at the likely next steps of central banks and how these could impact markets.

QE first reared its head in Japan in 2001, when the Bank of Japan (BoJ) became the first central bank to purchase government bonds financed by the creation of central bank reserves. This happened when the BoJ found itself backed into a corner as it approached the presupposed lower bound for nominal interest rates and needed to stimulate the economy. Following the global financial crisis, central banks in the US, UK and Europe were forced to follow suit, pumping large amounts of money into the banking system to prevent it from collapsing.

These measures have caused an array of consequences (intended or otherwise) that will need to be addressed sooner or later. At its core, QE has resulted in heavily indebted developed economies and has had varying degrees of success, which has arguably been dependent on the extent of distortions or frictions in the functioning of various markets.

Now that we are a decade on since the start of the crisis, surely it is time to think about what happens next to QE. Despite a fairly uniform decision to undertake QE across developed markets, the methods used have differed and so will the approaches to unwinding in the US, UK, Europe and Japan. The general market effects of QE have been lower discount rates, a weaker currency, and a strong environment for risk assets. Bank of England (BoE) studies have also shown there to be strong positive international spill-over effects of QE. Therefore, it is safe to assume that any rollback of QE would also have international impacts in such an interconnected world.

QE – When will we see you again?
Overall the inevitable unwinding of QE is getting increasing attention. Experts, including the IMF, are warning that an unwind could cause a super taper tantrum with increased volatility in the markets and a fight for remaining liquidity, as the supply of government bonds starts to disappear. There is unlikely to be a way to avoid a sell off when the ‘unwind’ begins. However, as long as inflation does not sky rocket, equities could continue on relatively unscathed for a time.

QE has served its purpose of being a life raft for many of the largest economies and now central banks must start to go back towards the norm of pre-crisis levels, so that they have ammunition to tackle the inevitable next crisis. Also, surely central bankers will not want to keep rates artificially low, as this could cause bigger problems such as a bubble in the bond markets. The developed world’s government bond markets are already showing characteristics of a bubble. However, if real interest rates were inappropriately low, shouldn’t there be evidence of over borrowing and inflation? Perhaps not, given the ever-present reluctance of investors since the global financial crisis after markets reacted so strongly to the news of bank failures. Maybe central bankers should use the focus the world’s media has on politics to go under the radar and ‘sneak’ in some rate hikes and reduce the balance sheet size while the politicians steal the limelight.

Encouragingly, the Haldane et al 2016 BoE working paper suggests that successive waves of QE have not been less impactful, so perhaps this will be a useful tool in the future. Though Janet Yellen has made it clear when addressing the Senate Banking Committee in her semi-annual report to Congress that: “We do not want to use fluctuations in our balance sheet as an active tool of monetary policy management.” Let us see how long the Fed sticks to that plan. For now, though, QE has helped markets get back on their feet to some extent and surely will have to be unwound if central banks wish to keep it as a potential measure again in the future.

Mark Burgess – CIO EMEA and Global Head of Equities – Columbia Threadneedle Investments