Quantitative easing has long been considered an effective strategy by many central banks that had hit the zero lower bound for nominal interest rates. However, the decision to buy ‘safe’ government bonds was questionable.
Rather, central banks should have bought risky assets, such as equity, as the Hong Kong Monetary Authority did over the 1997 Asia crisis. Not only would that have been cheaper – since the central bank would have needed to buy fewer assets – exit would have also been easier since these equities could have been sold at a substantial profit.
US and Europe’s approach
In a financial crisis, the central bank generally buys distressed assets whose price has been reduced by heightened risk aversion. As the crisis wanes, the price of these assets rises, making the exit strategy simple since the assets can be sold at a profit. At the start of the 2008 financial crisis, the US and Europe adopted this approach, with the Federal Reserve System buying distressed mortgage-backed securities and the European Central Bank purchasing peripheral sovereign bonds at low prices.
However, the strategy switched after the MBS market stabilised in the US. Periphery bonds recovered as the crisis abated and economic growth resumed. The Fed started buying ‘safe’ government bonds (or MBS issued by government agencies) to lower the risk-free long-term interest rate. The Bank of England began buying long maturity gilts at all-time lows in yields, while Deutsche Bundesbank and Sveriges Riksbank made significant purchases of government bonds at negative yields.
This was a dubious strategy for several reasons. First, since the risk-free rate is the lynchpin of all long-term assets, lowering it was always going to involve massive purchases. At the height of QE, the Fed, BoE and other central banks owned – and still own – significant proportions of outstanding government bonds.
Second, as is usually the case in a recession, risk aversion was elevated, and the price of ‘safe’ government bonds was high while the price of risky assets was low. This complicated the exit strategy since buying ‘safe’ government bonds was always likely to lead to potential losses if the strategy worked, the economy recovered and particularly if inflation rose.
Impact of quantitative tightening
Central banks have chosen different strategies to the problem of exit, or quantitative tightening, in part because they bought different maturities. The BoE, which bought significant amounts of longer-dated bonds, has chosen to sell bonds outright, thereby incurring large losses which have to be covered by general government deficits and are amplifying the fiscal deficit costs of higher interest rates. Purchasing riskier equity assets would also have brought the benefit of having part of the central bank exposed to higher inflation and nominal growth to balance overall portfolio risks.
By contrast, the Fed has chosen to let their bonds run off. They have slowed the speed of exit further by replacing most of the maturing bonds with new ones. By keeping the bonds to maturity, the Fed has avoided outright losses, but at the cost of a gradual exit. While the ECB has avoided outright sales – as the overnight rate has risen above the average yield that bonds were purchased at by some national central banks – losses have started to become material.
These exit issues could have been avoided if the Fed, the BoE and the ECB had chosen to buy cheap ‘risky’ assets, rather than expensive ‘safe’ assets such as government bonds. As the economy recovered, the price of these risky assets has risen and central banks would have been sitting on substantial capital gains, making the exit strategy much easier to manage.
This is exactly what occurred when the HKMA bought equity in response to the Asia crisis. It has been argued that the BoE and the Fed could not have bought risky assets given their mandate. However, over the initial crisis, the Fed did buy significant amounts of private securities – for example, equity in distressed banks through Maiden Lane Transactions, an off-balance sheet subsidiary. In addition, the operation would have been smaller, since the objective would have been to lower the risk premium on specific long-term assets rather than lowering the risk-free rate that underpins all long-term assets. But you do not need to go back to the 1990s to see the benefits of buying risky assets.
Safe-haven assets
The Bank of Japan decided to implement QE by buying a wider portfolio of assets, particularly equity exchange-traded funds. The gains from the appreciation of these risky assets have been larger than the losses on its ‘safe’ bonds, so the BoJ’s exit strategy is now much easier and presents much less financial loss risk to taxpayers. The benefits of buying ‘risky’ assets can also be seen in other countries in the euro area, such as Greece, Ireland and Portugal, who bought their government bonds at a steep discount since they were regarded as risky by the market that wanted to hold ‘safe-haven’ German bunds.
QE was employed as a bold move after the 2008 financial crisis when there were real fears of a new ‘Great Depression’. However, as often happens in the heat of the moment, the implementation was flawed. Central bankers were lured into buying seemingly ‘safe’ government bonds for too long a period. This was chosen over ‘risky’ assets despite the fact they were almost certain to face mark-to-market losses on these ‘safe’ assets rather than booking large gains on ‘risky’ ones. This has resulted in excessively bloated central bank balance sheets and complicated the exit strategy as major central banks have been reluctant to sell the bonds they own at a loss.
15 years after QE was initiated as an emergency strategy, it is time to thoroughly assess the chosen approach so that the next time central banks need to buy assets to support the economy, the risks and benefits are better understood.
Tamim Bayoumi is a former Deputy Director at the International Monetary Fund and Mark Bathgate is Managing Director of Tweeddale Advisors.
