On misunderstanding QE | FT Alphaville

On misunderstanding QE

There are literally a thousand notes in our inbox this Jackson-Hole Friday morning, going something like:

Bernanke unlikely to pave the way for QE3

And most of them put it down to: a rebound in core inflation to a 19-month high of 1.8 per cent in July. Or such the like.

That is, maintaining the ruse that QE is an inflationary danger (at this point in time).

We’re quoting Capital Economics in this case, but the same applies to most of them.

None of them mention what we think is a much more likely reason for why there won’t be a QE3 announcement. That more QE is not only pointless, but dangerous. And not for inflationary reasons, but for the exact opposite reason. It’s dangerous because more QE at this point in time — unless its structure is modified drastically — might only prolong the liquidity trap or make it worse.

While we won’t say QE doesn’t have the capacity to become an inflation problem one day, and even go as far as to say there might have been a danger of this earlier this year, it’s just not the case now. Expectations have flipped completely the other way. And in a liquidity trap, expectations are everything.

There are thankfully a few notable voices citing our case.

One is Michael Woodford in an opinion piece in the Financial Times on Friday, who points out to what degree the economic theory behind QE has always been flimsy.

As he states:

Some argue that, even if the effects are small, it is worth trying QE3 given the dismal outlook for the US economy. But a further round of easing could actually do harm, by giving policymakers an excuse to avoid taking actions that would do more to help the economy. The decision to purchase assets last November, for instance, allowed the Fed to sidestep calls for greater clarity on its future policy targets.

If QE2 had any impact, it probably came from the signal it sent about future Fed policy. Inflation expectations increased after the announcement, because those Federal Open Market Committee members who wanted a return to more orthodox policies seemed to have lost the argument. But this is surely not an ideal way to send a signal: expectations can be shaped far more effectively by speaking directly about future policy, rather than leaving it to be inferred from actions that have no definite implications for the future.

Essentially, it was the expectation management that emerged from QE that was useful. Not the QE itself.

Meanwhile, if anyone explains it best, it’s probably Cullen Roche at Pragmatic Capitalism. Yes, he’s an “MMT-type”.

But to be fair, even he says QE2 might have had a chance had it focused on price rather than size. However, because it didn’t, there was never going to be a transmission mechanism. QE, thus, became anything but debt monetisation. The myth of debt-monetisation, nevertheless, lived on. (And was possibly even encouraged.)

As he notes:

Most investors did not believe this perspective and maintained that QE2 would not only cause surging inflation, but would also cause US government bond yields to surge when the program ended. This was primarily due to the many myths that have persisted surrounding QE2. These were the myths of “debt monetization“, “money printing” and “stimulus”.

These are nothing more than common misunderstandings, but investors who listened to these myths failed to assess how QE2 would impact the asset it targeted – US government bonds.

And who was the biggest peddler of the debt monetization myth?

Roche identifies Bill Gross of Pimco — the world’s largest Treasury bond fund:

None of these misinterpretations was more famous than Bill Gross who incorrectly analyzed QE1, but also misunderstood QE2.

For example, the WSJ has since pointed out that Gross’s Pimco fund has been a laggard this year on account of that bearish view. But in Roche’s opinion they are failing to join the dots:

You see, what PIMCO misunderstood, was not just the impact of QE2, but the actual operational realities of the US monetary system. We’ve tracked PIMCO’s comments in real-time and called them incorrect at several points in the last year. For instance, earlier this year, Bill Gross said June 30th could be “D-Day” when the US government could experience a shortage of buyers in government bonds which would lead to surging yields.

Bill Gross asked “Who will buy the bonds?” Mr. Gross misunderstood how government bonds function to “finance” the US government (they don’t). And in doing so, he misinterpreted how government bond auctions work. I said these funding fears were unfounded and unlikely to impact bonds. Last year at this time, I vigorously argued that US Treasuries were not in a bubble. And just days before an epic 10% surge in long bonds I said US Treasuries served as part of “the perfect hedge” in this environment. I followed-up to these pieces in greater detail than I cover here (I’ll spare you the repetitious commentary).

The point here is not to say “hey look at me, I was right and Bill Gross was wrong”. The point is that understanding the monetary system matters.

The question is did Gross really misunderstand?

Or could he possibly have taken one for the team? Because the team (the Fed and the Treasury) believed that the myth of debt monetization served their purposes by heightening inflation expectations? Until, of course, they realised those expectations were flowing out in totally non-useful ways (that is, into emerging and commodity markets).

Who knows. You never can tell with Jedi mindtricks.

But what we can tell you is that Mohamed El-Erian, chief executiveve and co-chief investment officer of Pimco, is saying the following in an opinion piece on Friday:

In the event, QE2 pushed financial investors out of the risk spectrum and delivered higher asset prices. But it failed to convince companies and households to consume, invest and hire more. As a result the Fed-induced wedge between market levels and underlying fundamentals eventually collapsed under the weight of artificially high valuations.

To be sure, Mr Bernanke was among the first to acknowledge that the benefits of unconventional policies come with costs and risks. Specifically, QE2’s benefits – in the form of “good” inflation (higher prices for equities and corporate bonds) – were coupled with collateral damage (“bad” inflation via surging commodity prices) and unintended consequences (technical market dislocations and the Fed becoming more vulnerable to political attack).


All this serves to tilt Mr Bernanke’s policy equation towards greater costs and risks. Accordingly, rather than embark on another policy initiative (“QE3”) with questionable net benefits, it would be better for Mr Bernanke to use his Jackson Hole speech to reframe the national policy debate and, in the process, set the stage for President Barack Obama’s key economic announcements on September 5.


He should do so in three steps. First, acknowledge that the considerable headwinds undermining economic growth and jobs have important and growing structural elements. Second, explain why a sustainable solution must go well beyond Fed financial engineering and, specifically, incorporate co-ordinated structural reforms on the part of agencies responsible for housing, the labour market, public finances, infrastructure and directed credit. Third, and most delicate, caution that another round of unconventional Fed policies would only be effective if accompanied by these other policy initiatives.

Failed to convince“, resulted in “bad inflation , needs to “set the stage” for President Barack Obama for solutions that “go well beyond Fed financial engineering”, and be “most delicate” in explaining why more unconventional policy in its old form simply won’t work. (I.e. without directly admitting that debt monetization isn’t a risk, just in case we need that weapon in our arsenal one more time.)

We don’t know about you, but to us that sounds like a) El-Erian ‘gets’ the situation very well and b) is mainly engaging in expectation management.

It’s time to move onto new policies, but let’s not directly mention that there’s no chance of inducing “the right sort” of inflation through money-printing. Just in case.

Related links:
An important lesson from Jackson Hole 2010
– FT Alphaville
Introducing the 2011 deposit crisis
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Shadow banking – from Giffen goods to Triffin troubles
– FT Alphaville