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Selective Quantitative Easing – A Brave New World of Monetary Policy

Garrett Fisher
February 22, 2022

When quantitative easing (QE) was devised in the United States, it was received as an innovative positive mechanism. Since Congress would not address economic issues from a political perspective, the Federal Reserve got creative, potentially avoiding a double dip recession. The European Union later copied the facility, as did some other major central bank institutions.

As time went by, there was a slow-burning fear that QE is a backdoor form of inflationary money printing. As asset prices continued to climb across the board, some disquiet developed about the long-term consequences of such monetary policy innovation. Appropriately at the time, the Fed pivoted from QE to quantitative tightening (QT) before the onset of COVID-19. As I articulated a few times in economic fundamentalist terms, the question at the time was, could we amortize the size of the Fed’s balance sheet in time before the next recession? The premise of the question was that such financial unorthodoxy best be utilized for the shortest period of time. If it persisted, it felt as though we were setting ourselves up for a problem.

The short answer is that QT could not get very far before COVID-19 arrived, which resulted in a massive experiment never before attempted, on multiple levels. If anything, it taught us something that Reagan was cynically quoted as saying: “deficits don’t matter.” When one holds the power of seigniorage in the world’s reserve currency, it might not.

The simple fact is that “electronic money printing” differs greatly from physical money printing. Money printed to purchase government bonds, pushing sovereign and commercial interest rates down is a task of limitless ability, with the consequence of eventual inflation and asset bubbles. At any time, the reverse can be implemented. Gone are the days of wheelbarrows of trillions of marks to purchase a loaf of bread in Weimar Germany. If things get too frisky, the Fed can electronically reverse course, with nothing other than broader inflationary consequences. Nobody has to chase down all that paper currency and clean up the mess.

Congress figured this out too, by embarking on the largest spending event in American history during COVID-19. It then followed that with the largest non-emergency spending event in American history. No longer must one worry if the market will purchase the bonds, or at what interest rate; the Fed will do it.

In any case, the mandate of the Fed is to maximize employment while keeping inflation in check, with a specific goal to avoid destructive deflation. Thus, QE and QT are permanent tools in the toolbox of monetary policy, alongside the federal funds rate. These tools have spread to the eurozone, Canada, the UK, and other major economies.

I feel that we are seeing QE and QT through much too binary of a lens. After all, it has been implemented in a binary fashion since its inception. We had QE, then QT, then QE, and we’re about to have QT again. One could swap the Es and Ts for “rate lowering” and “rate raising” campaigns, which tend to operate in binary cycles.

Much of the binary nature of quantitative cycles relates to market messaging, intentionally communicated by the Fed. The Fed would like the economy to know liquidity is being pumped in and, when people we’re getting nervous about this brave new world order, that it was being reversed in the name of good sense. When the pandemic hit, the words from the Fed Chair that the central bank would “do whatever it takes” had the same power as when Mario Draghi uttered them to save the Eurozone monetary union a decade ago. Markets breathed a sigh of relief. Now, as inflation is raging, messaging is specifically telegraphed to convey less accommodative conditions, hoping the market gets the idea.

In the near future, we will likely enjoy a period of consistent QT as central banks try to reach their goals. At some point in the midterm future, we can expect a recession to materialize, of unknown intensity. QT may not be appropriate at that point, though QE may not be either, as it will be evident that our economies are addicted to cyclically progressive expansions of central bank balance sheets. In other words, if we do not keep the printing presses running, we would experience “dynamic disassembly,” a verbose synonym for “when the whole sonofabitch comes apart.”

The functional essence of QE that soothes the ravages of the bond market is liquidity. If enough liquidity is pumped into the system, then we do not have to face default events, which have a way of creating domino effects. The much-feared hypothetical depression/financial implosion/currency collapse/market apocalypse is when the dominoes “cannot” be stopped, and they take down the entire banking system with it. I say “cannot” in quotes as, in the period of 1929 to 1932, the US administration effectively refused to act outside of a laissez-faire non-interventionist approach, allowing the dominoes to continue unabated. The administration in 2008 attempted to allow the free market to operate without interference until it was evident that the dominoes were about to fall over, so the government intervened to stop the collapse. In 2020, we barely let a single domino start teetering before governments stopped it. Dominoes falling is a subjective decision, based on how interventionist governments and central banks wish to be; however, intervention comes at the cost of long-term inflationary realities. We simply cannot turn the clock back to 1980s market pricing fundamentals, as it would be the end of our societies as we know it.

That is a long way of saying that we are likely stuck with the size of current central bank balance sheets into perpetuity, unless the winds of political will reach a tipping point where it is decided to allow the economy to take its medicine. Even if a severe collapse were allowed, it likely would be curtailed at some point, by the same monetary policy tactics as before. All the Fed has to do is print money and purchase collapsing assets, and the market will react to the dynamic. It is impossible to not have prices respond to such a massive buyer.

There is some lack of utility focusing on the most extreme of circumstances. The much-feared apocalypse is likely some time off, it at all, and would depend on a number of black swan events to converge. In the meantime, we have a new equilibrium that will likely emerge now that QE and QT are permanent fixtures of the global economy.

I postulate that central banks will use more surgical implementations of QE and QT to nudge, massage, and operate upon sickly sectors of the economy. A case in point is the example of Greece during the pandemic. Greece was the precipitating problem in the eurozone crisis, where their sovereign debt collapse nearly brought the failure of the entire eurozone monetary union. The reason was a) that market forces presented an actual problem with Greek sovereign bonds and b) European Union treaty mechanisms prohibited a bailout from the European Central Bank or other EU institutions to other countries. The EU was locked into a currency union but could not take the steps to prevent its collapse.

That situation was awfully like the 1929-1932 situation, where the position of the government in the US was that it “couldn’t” intervene in any meaningful capacity. It was wedded to the currency and prospects of the nation, but it wouldn’t act to rescue it. For the EU, Germany eventually blinked and agreed upon a de facto bailout, which ended the prospect of eurozone collapse.

Greece remained dependent on outside financing until the COVID-19 pandemic. When that struck, the European Central Bank engaged the Pandemic Emergency Purchase Programme, ostensibly to prevent sovereign debt collapse due to pandemic realities. It was an expansion of QE, worded in a way to satisfy EU treaty wording. Funds from PEPP were used to purchase Greek bonds (among other things) which, while it helped alter normal market effects from the COVID-19 shock, it also continued to offer life support to Greece, to the point that, when the ECB recently announced the curtailing of PEPP, Greece requested that the ECB continue to purchase its bonds.

Why was that important? A common measure of eurozone fiscal stress is the spread between Italian or Greek and German bonds. Both are denominated in euros. Germany is clearly to the point of not being a credit risk, whereas the Mediterranean countries are. If the spreads get out of control, it is a sign that market forces are working in their purest sense, punishing weaker Mediterranean countries for their fiscal position, resulting in a potential death spiral of highly expensive interest rates, which would result in the dominoes falling for the country in question, and eventually the eurozone.

Recall that, prior to the pandemic, Italy was on the rocks economically. There was concern that an extremist, anti-EU political party would end up gaining power, as Italy’s economy had been flagging for some time. At a size vastly larger than Greece, Italy’s demise would have been the end of the eurozone. Curiously, we do not speak of Italy nor Greece at this point, as “emergency liquidity to counter the pandemic’s effects” from the ECB has smoothed those cracks.

QE alters market conditions. In the purest sense of capitalism, Italy and Greece would have little choice other than to march toward ruin, exit the eurozone, and recapitalize with new currencies or make structural changes to a level of success that has thus far evaded them. One could say that they are partially insolvent, which means that investors should not be lending to them at cut rates. QE has substantially eliminated the sovereign debt spread between Germany and Italy, in the name of first avoiding deflation, and later to blunt the shock of the pandemic. In a situation where the ECB begins QT to dent inflation, market forces would come roaring back and pummel Mediterranean sovereign debt.

This is where I propose that central banks will adopt a new, permanent stance of “selective QE.” Whilst possibly messaging in line with some kind of inflation mandate, central banks could throw morally hazardous yet small sums of money at incidental market “weaknesses,” altering market conditions to avoid dominoes falling. While part of the act would be a counterweight to market extremes and irrationality, part of it would be a form of government intervention in markets that would be experimental and novel in nature. It would operate outside the scope of normal QE/QT inflation/deflation cycles.

This kind of intervention exists in two forms. First, Switzerland undertakes a unique form of it. As Switzerland has little sovereign debt, they cannot engage in QE in the same form as other western economies. That poses a risk that the Swiss franc would rise to damaging heights; thus, the Swiss National Bank operates a virtual trading desk that purchases foreign assets (selling francs) at various points, in various amounts, when it deems necessary, based on the SNB’s interpretation of the franc’s value. This is selective central bank intervention, par excellence.

The second form is called “bailouts.” The Fed did it with Long Term Capital Management in 1997 and with Bear Stearns in 2008. When a deemed systemically important entity stands a risk of going under, they have acted, though usually at the severest of duress, and with consequentially significant market signaling. If the Fed is “bailing out” someone, then surely where there is smoke, there must be fire?

In the context of massive QE employed in 2020, words such as “bailout” were not used, and specific targets were not announced. The message was about the need to insert accommodative liquidity into the system to counter a virus’ effects, not Italy or Greece’s ongoing problems. However, what central banks chose to deploy those funds for has the same powerful and selective systemic outcome as a bailout. I contend that the future will be one where incidental, unannounced, Swiss National Bank style “quantitative easing” will be used to smooth economic bumps, plug holes in the system, and cover for dominoes that appear to fall. It can be done without massive infusions of funds in the likes of ongoing QE campaigns.

In some ways, it is a natural outworking of the world we live in. Since we are likely stuck with large central bank balance sheets into perpetuity and cannot go back to old pricing mechanisms, we need the gift of time to allow economic adjustment to high asset prices, while doing what we can to avoid large, expansive QE campaigns that exponentially amplify the reality that we are now stuck with. Life may be somewhat better off as selective QE would be Keynesian and potentially countercyclical at heart, though it would be filled with a minefield of capitalistic moral hazard, though most do not care as long as their stocks continue to go up.