LONDON (Project Syndicate) – Ahead of the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyoming, last month, discussion had centered on whether to tighten monetary policy in response to higher US inflation.
By suggesting that asset purchases be reduced first and rate hikes come much later, Fed chairman Jerome Powell has shifted the conversation to how policy should be streamlined.
It is understandable that at the height of a financial crisis, a central bank would print money to buy assets. But continuing such a policy under conditions of relative calm makes little sense – and carries serious risks.
While printing money to buy bonds and lowering long-term interest rates is justified in crises like 2008 or 2020, maintaining quantitative easing (QE) is far from obvious in quieter times. To see why, it helps clear up three misconceptions about QE.
The first misconception is that QE is monetary policy. It is not. Or rather, it's not just that. It's also a fiscal policy. In each country, the central bank belongs to the Treasury. When the Fed spends money – actually central bank reserves – to buy a government bond, the private sector gets one government debt in exchange for another.
The second misconception is that the government (including the Treasury Department and the central bank) always has the edge in such a transaction because the private sector holds a security with lower interest rates. It doesn't have to be. Central bank reserves can only be held by commercial banks who have only a limited use for them. To get banks to hold more reserves, central bankers have to pay interest on it, as the Fed and Bank of England did in response to the 2008 financial crisis.
The third misconception is that the state can spend what it wants and when it wants if the interest rate on central bank reserves is zero or less than the interest rate on government bonds. This is the central principle of the so-called modern monetary theory. It's pithy, chic, smart, and fake.
It is cheaper (for US taxpayers) to fund expenses by issuing bonds than by printing money.
Yes, financing through money creation (economists call this seigniorage) is always possible if the return on money is below that of government bonds. But as the central bank prints more and more money, it has to pay higher and higher interest rates on that money to ensure that commercial banks and the public want to keep it.
Sooner or later the interest gap will close and there will be no more seigniorage. If the central bank continues to print money past this point, the private sector will start dumping it, resulting in currency devaluation, inflation, or both.
QE doesn't make sense today
Once you accept these three caveats, you have to ask yourself the multi-trillion dollar question: Does QE in the US make sense today from a fiscal perspective? The answer is no for at least two reasons.
At the end of August 2021, the Fed paid 0.15% interest on the reserves of commercial banks at a time when the interest rate on short-term Treasury bills
fluctuated 0.04%. This means that it is cheaper (for US taxpayers) to fund expenses by issuing bonds than by printing money.
This may seem paradoxical. However, it is important to remember that the rate of return is a proxy for liquidity. Reserves at the Fed can only be held by banks. They are not used as collateral and are subject to capital requirements. Government bonds, on the other hand, can be held by anyone. They are traded in a huge, deep market and are routinely used as collateral for other financial transactions. No wonder investors see Treasuries as more liquid and demand a lower return from them.
Debt maturity is the other reason why additional quantitative easing makes little fiscal sense. There are government bonds in many terms of up to 30 years. But the part of the Fed reserves that is not needed comes in just one term: immediately (since the commercial banks can withdraw them at will). Therefore, every time the Fed issues reserves to buy a long-term bond, it lowers the average maturity of government bonds.
Such a policy would be sensible if interest rates on long-term government bonds were high. But the interest rate of the often cited 10 year treasury
now well below the Fed's rate of inflation for that period, meaning people around the world are effectively paying for the privilege of handing their money over to the US government for the next 10 years.
In these circumstances, as Lawrence H. Summers recently argued in the Washington Post, the correct policy is to “cancel” the sovereign debt – that is, to hold the very low interest rates for as long as possible – and not to do the debt like the Fed does with QE. Here is a government like a family looking to take out a mortgage: the lower the long-term interest rates, the more sensible it is to borrow long-term.
Interest rate risk
The homebuyer analogy also highlights the other risk introduced by short maturities: the risk of future interest rate hikes. In the US, where 30-year fixed-rate mortgages are common, a new homeowner doesn't have to worry about what the Fed will do with interest rates over the next year – or even decades. But in the UK, where adjustable rate mortgages are the norm, homeowners are always worried about what the Bank of England will do next.
The US federal government has followed UK homeowners in managing their debt. While interest rates won't rise tomorrow, they certainly will one day, and when that happens, adding to huge stocks of debt at higher rates of return will incur a not inconsiderable fiscal cost.
One can also imagine nasty financial dynamics: a rising interest burden causes more debt to be issued, and this increase in supply reduces the liquidity premium on the new bonds, which further increases interest rates and requires ever larger bond issues.
In addition, unsavory political dynamics could arise. If central bank decisions have a major impact on public money, politicians will be more tempted to persuade central bankers to keep interest rates low. Skeptics will counter that something like this doesn't happen in the US. But America’s former president wasn’t shy of intimidating the Fed on Twitter, which it shouldn't have done. (Presidents like Donald Trump shouldn't happen either.)
These are not arguments for a more restrictive monetary policy; the Fed can keep the short-term rate as low as necessary. Nor are they arguments for a more restrictive fiscal policy; If the Biden government wants to spend more, it can issue long-term bonds or raise taxes.
It used to be progressive to print money to pay the deficit. No longer.
Andrés Velasco, former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and articles on international business and development and has served on the faculties of Harvard, Columbia and New York Universities.
This comment was made with permission from Project Syndicate – Breaking Bad Bond Buying. released
More about tapering
Powell is risking his legacy if he doesn't start reducing soon
Reduce your pessimism – Fed action won't derail US stocks, say Barclays strategists
Fed Chairman Powell says he supports reducing bond purchases this year