Sunday, September 16, 2012

The dangers of more monetary accommodation

Over the past few days, monetary authorities on both sides of the Atlantic have announced further extraordinary monetary accommodation policies. 

In Europe, the ECB finally bowed to pressure and announced  an ambitious program, dubbed "outright monetary transactions”, to purchase an unlimited amount of eurozone sovereign debt with maturities of between one and three years. The ECB's bond buying program, though conditional on governments signing up to a European Financial Stability Facility or European Stability Mechanism programme for fiscal and structural reforms, comes despite strong opposition by the German Bundesbank. Further, the ECB would not be treated as a preferred creditor in the event of default, thereby signalling to investors that the ECB purchases will not subordinate their own holdings of peripheral country bonds. This is part of ECB's determined effort to do "whatever it takes" to save the Euro. 


In the United States, spurred into action by the persistent dismal unemployment figures, the Federal Reserve announced its third round of quantitative easing program, QE3. It has decided to inject an extra $40bn into the economy each month through purchases of mortgage-backed securities for an unlimited time till the labour market improves. The FOMC reported
The Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative... the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
As the FT reports, this marks a significant strategic shift in the Fed's policy stance. It has now, for the first time tied policy to developments in the economy – and promised not to shift policy until it succeeds.

For the record, the QE1 in 2008-09 involved purchases of $600 bn in mortgage backed securities and agency debt, $1.25 trillion of agency MBS, $200 bn in agency debt, and $300 bn in Treasuries.  The QE 2, from November 2010 to July 2011, involved purchases of $600 bn in similar securities. The most recent Operation Twist in September 2011 involved a swap of $400 bn of Treasuries to achieve maturity transformation and lower long-term rates.

The underlying premise behind both these actions in the US and Europe is the belief that liquidity injections will somehow help address the underlying problems and help the respective economies back on recovery path. In other words, this view sees the current problems as mainly liquidity problems, which can be tided over by an extended period of monetary accommodation.  

Unfortunately, this view may be deceptively misleading and could lead us down the path of even more pain. The best that can be said in favor of this policy is that monetary accommodation will help buy the time required to address the fundamental structural and fiscal problems. Though extraordinary monetary accommodation has been going on for nearly 5 years now, governments have done precious little to address the fundamental problems in the real economy. Nor is any inclination on their part to do anything different. And all along, things may have steadily gotten worse.

Europe's problems, certainly that of Greece, cannot be addressed by merely buying time and hoping that the denominator in the debt-to-GDP calculus improves with time. Fiscal austerity has already deepened it to a level from where all the possible options may have been shut off. In case of the US, while financial institutions' balance sheets have been repaired, very little has been done to address the balance sheet problems of the households. Further, no amount of central bank aggression will address the real problem of persistent unemployment rate and output gap, as well as the longer term debt problem arising from health insurance expenditures.  

And associated with any cheap money policy is the resource mis-allocation dangers, both domestically and globally.  Ruchir Sharma summed it up nicely,
The Fed can print all the money it wants - but it cannot dictate where it will go. The frst two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10%, with food up 15%, while oil prices rose a further 30%... Now, there is a tight link between stocks and commodities, with prices rising and falling in lockstep. This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit... a third round of quantitative easing... could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping poing for the global economy in the past.

Financial market distortions caused the sub-prime crisis and if conditions of extended accommodation persist for too long another bubble may get inflated somewhere in the wide markets. More worryingly for the developing countries, in a world awash with liquidity in search for returns, their economies offer attractions for speculators looking for quick bucks. This is all the more so given the diminishing investment options in the developed economies. Such capital flows, as we already know from several recent experiences, can have damaging consequences. In the circumstances, from the perspective of developing economies, is some form of capital controls desirable?

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