American investors seem tired of quantitative easing. No one less than Carl Icahn said it’s making the market sick.
But at the same time, the stock market soars when one Fed official suggests the central bank might extend the program for three months.
With the Fed set to wind down the controversial program as early as Wednesday, Stephen Cecchetti, an economics professor at Brandeis University, helps explain the purchases. He’s spent more than 30 years studying central banking, with the last five as head of the monetary and economic department at the Bank of International Settlements, the central banker’s central bank.
Cecchetti said he doesn’t understand why investors get so agitated by quantitative easing as it hasn’t led to a surge of money printing. And he said the program has worked in the U.S. and will work in Europe provided they get aggressive enough.
MarketWatch: Former Fed chairman Ben Bernanke once quipped that QE works in practice, but not in theory. What’s your view? Has it worked?
Cecchetti: The short answer is yes. It’s worked. The question is “what is it and why” and I think we want to distinguish between three different policy tools. The first one is the increases in the absolute size or scale of the central bank’s balance sheet. The second one is the change in the central bank’s balance sheet composition, or the mix of assets that they hold, and the third one is forward guidance about where their interest rate targets are likely to be in the future. And so each one of those works a bit differently, I think we understand that now. But they all work and QE as it is construed in the popular press as well as in the policy world has to be divided up into those three things.
MarketWatch: And all three things worked?
Cecchetti: They work in different ways. The one that doesn’t always work is the increase in the absolute size of the balance sheet. That one is only going to work in conjunction with the forward guidance. So if it is reinforcing the signal of the forward guidance – things like, we’re going to keep our interest rates low for the next three years – or some statements like that central banks make - then I think it’s going to work. The one where you change the mix of the composition of assets – that one works, I think, pretty much all the time.
Let me back up a little bit. The most important thing to understand is the way that monetary policy works is by changing financial conditions. That is how conventional and unconventional monetary policy work. And so, you can change financial conditions by changing current interest rates, by changing expectations about future interest rates, by changing term premia associated with long rates or by changing risk premia that are associated with a variety of other kinds of financial instruments. And monetary policy, in one way or another, operates through all of those channels.
MarketWatch: Do you think QE has a good chance to work in Europe?
Cecchetti: I think it could, yes.
MarketWatch: The way they have it structured now?
Cecchetti: I think that they need to be more aggressive than they appear to be right now. I think that they would certainly need to try and increase the size of their balance sheet pretty significantly. Their balance sheet is roughly 1 trillion euros below the peak in March 2012. And I think they would need to address that by finding securities that they would need to buy. A program that would actually increase the size of the balance sheet from the March 2012 level would have to be on the order of 1.5 trillion euros of outright purchases. And the question then is what should they be purchasing, and are those securities around? I am not the person to ask about what legal restrictions the euro system faces in doing that, so I think it is quite complicated. Nor am I the person to ask about things like what the internal politics of Europe are about it. They have a difficult road, but there is a path that they could take.
MarketWatch: And the sooner they get more aggressive, the better?
Cecchetti: That of course has been true for a while and I think they’ve generally known that. There are legal and political barriers to doing this. There are also differences of view across the euro area about what the right way is to proceed.
MarketWatch: So QE changes conditions in financial markets?
Cecchetti: Not just that, it changes the trade-offs that people see, it changes the environment in which they are doing their consumption and investment. By that I mean people are buying stuff and borrowing and firms are actually engaging in new activities, and so it changes the relative riskiness of those things as well.
MarketWatch: Your replacement at the BIS, Claudio Borio, said during the recent International Monetary Fund meeting that there is risk-taking going on in financial markets, but not in the real economy. Is that your sense?
Cecchetti: That may be true in Europe. I don’t see that that is necessarily true in the U.S., [where] we’ve seen investment rebound. In different parts of the world, things are operating quite differently. It is also the case you are seeing pretty strong investment and consumption in a lot of emerging market countries too. You don’t want to make blanket statements about the whole world.
MarketWatch: But I wanted to get at whether QE is helping that along, people taking more risks in financial markets?
Cecchetti: The whole point of monetary policy during periods when output and employment are below their potential is to get people to take risks that they otherwise wouldn’t take. That is the monetary policy transmission mechanism. So the question to ask is whether or not it has gone too far. And it is hard to argue that it has gone too far when output and employment remain depressed and inflation remains low. And also, if it is the case that your financial supervisors are doing their job, then I don’t see this as being a huge issue. If I look at U.S., the financial system looks pretty well capitalized, there isn’t a huge amount of lending going on, credit is far below its peak of 2007. The places where there are issues are in Europe where the banking system still remains undercapitalized and that is the case seven years after the start. The crisis began in the summer of 2007 in Europe. The recapitalization of the American banking system started and then occurred in real force beginning with the release of the original stress test in May 2009. And so I just don’t see where these risks are.
MarketWatch: Carl Icahn seemed to capture one popular view of QE recently when he said the Fed has given the U.S. economy too much medicine and now doesn’t know how to stop. And every time the Fed says it wants to cut back the medicine, something happens to the patient. What’s your reaction to that?
Cecchetti: The question is why is it that people so upset about the size of the Federal Reserve’s balance sheet. The Fed’s balance sheet is of course much smaller relative to GDP than say the champion of the world today which is the Swiss National Bank. The assets of the Swiss National Bank are about 90% of Swiss GDP. Now maybe people in Switzerland think there is a problem with that but generally the reason that that has happened is that there has been an attempt to keep the Swiss franc exchange rate at 1.20 Swiss francs to the euro or higher and the result has been this big expansion in their balance sheet. But I am not sure that the absolute size of the balance sheet really matters. I think in the end it’s pretty arbitrary.
The Fed’s balance sheet probably will shrink. But it actually doesn’t really even have to. Not if they don’t want it to. They could run their policy with a balance sheet of the size of what it is now, roughly $4.5 trillion, which is on the order of 30% of U.S. GDP, probably pretty much indefinitely if they wanted. And I think they could do that without a huge amount of harm. So I don’t see a problem that other people see with a balance sheet of this size. And the main reason is that the monetary base, the reserves being supplied to the banking system, are not being turned themselves into money as conventionally defined. So M2 growth has not been totally out of whack. And that’s because the money multiplier is pretty low. So I am not that concerned.
MarketWatch: Do you think the Fed will be able to raise interest rates anytime soon? The market has pushed back when it expects the first rate hike.
Cecchetti: Any view about interest rate policy is conditional on economic events. The FOMC statements and the chair’s public statements both in speeches and at the quarterly press conference are pretty clear about that. That said, I think the American economy looks like it is doing pretty well. And most people have felt that the second quarter of next year you should start to see interest rate increases. Look, I am not an active investor. I am not putting my money where my mouth is on this one, but sometime around the middle of next year seems pretty reasonable.
MarketWatch: Inflation has been low. What’s your inflation outlook?
Cecchetti: I think wage inflation is starting to increase somewhat. I think that will feed itself into price inflation. One of the reasons inflation has been relatively low has been the strength of the dollar, which has reduced the price of imports and the price of oil, which has fallen pretty dramatically. Those tend to be relatively transitory things in terms of their impact on inflation. So I think forecasts by the FOMC itself and others that inflation will slowly over the next few years make it back to 2% certainly seem reasonable. The question is whether or not the FOMC is going to believe there is a reason to allow inflation to rise above 2% briefly in order to sort of make up, if you will, for the relatively low inflation period and get back to a price path that has an average which it did from roughly 1981 or 82 to 2006, inflation under the personal consumption expenditure deflator averaged 2.1%. The last six or seven years from the beginning of the crisis, or a little before, have averaged a bit below that. They could certainly run 3% inflation for a few years to average out again to numbers like 2% or 2.1%. The question is will they do that, or are they going to stop at 2%. So I guess we’re going to have to see.
Marketwatch: Sounds like a high-class problem at the moment.
Cecchetti: It is going to be a pretty nice problem to have to worry about whether inflation should rise over 2% and stay there over a few years. In most of the advanced economies of the world, they would be ecstatic.
MarketWatch: Any signs of asset bubbles?
Cecchetti: Real estate prices in the U.S. are still nearly 20% below their pre-crisis peak, the average national price. I think housing is fine, equity may be a little bit higher than long-run, sort of Bob-Shiller-like numbers, but probably not huge. Are there parts of the world where real estate prices might be rising very rapidly that might be problems? Well, I don’t know. My understanding is that London real estate prices have gone up very rapidly and the question is whether or not the influx of money from parts of the world where there has been political upheaval has driven that, and if so whether that is a transitory thing or whether it is going to fall. There are parts of Canada where Canadians are concerned. My concern is always with leveraged investments and whether or not those prices have gone up substantially, because if they do fall and there is a lot of leverage then you tend to see defaults, and if the loans have been provided by banks it can ripple through the financial system. So these are things to watch.
MarketWatch: Would Fed liftoff send a shock through the financial system?
Cecchetti: There has been a lot more capital flow volatility in the last few years than people like and along with that has come exchange rate volatility. My view is that investors are looking for places with good growth prospects, and as long as those economies growth prospects remain good in the emerging market world and rates of return remain healthy, that people are going to continue to diversify their portfolios and put their funds there. And a small move in the riskless real rate in the U.S. — that tends to follow, not lead the fact that real returns on the U.S. have gone up — shouldn’t have a huge effect.
