Misconceptions About Fed’s Bond Buying

Misconceptions About Fed’s Bond Buying

To combat the recession that began in 2007, the Federal Reserve and some other central banks have been buying large amounts of long-term bonds. The novelty of this quantitative easing makes the policy especially prone to popular misconceptions.

Misconception No. 1: QE bond purchases are comparable to stimulus spending on roads and tax cuts, which adds to the national debt.

— QE actions to lower long-term interest rates require much bigger changes in the Fed’s balance sheet than conventional policy aimed at short-term interest rates. The “Q” in QE is the quantity of assets purchased — and the dollar amounts are necessarily very large. But QE is a swap of one asset (bank reserves) for another (bonds); this has no direct effect on the national debt. Indeed, QE indirectly shrinks the national debt by reducing interest payments and by strengthening economic activity, which raises tax revenue.Misconception No. 2: Any effect of QE on long-term interest rates, and hence on economic activity, is small and temporary. That’s why bond yields are higher now than a year ago and the economic recovery remains sluggish.

— Studies show that QE has a large and long-lasting effect on bond yields. The evidence for an effect on economic activity is weaker, but consistent with a positive effect. It is well established that monetary actions that reduce short-term interest rates stimulate activity, and there’s no reason to doubt that monetary actions that reduce long-term interest rates do the same. It’s normal for bond yields to rise as recovery proceeds, but yields are still much lower than you would expect given the state of the economy and the large increase in federal debt. The recovery is sluggish because of lasting damage from the bursting of the housing bubble, fiscal contraction at all levels of government and weakness in the rest of the world, especially Europe.

Misconception No. 3: The main lasting impact of QE is to raise stock prices, which disproportionately benefits the wealthy.

— Any policy that supports economic recovery is good for stock prices, and does benefit the wealthy. But a more vigorous economic recovery also increases employment, which disproportionately benefits those who aren’t wealthy. Lower long-term interest rates benefit borrowers, who tend to be poorer, and harm savers, who tend to be richer.

Misconception No. 4: QE is disrupting financial markets and encouraging risky and wasteful behavior.

— To the contrary, QE has helped to keep markets liquid and healthy. By supporting economic recovery, QE reduces the risk of market panics and the threat that big financial institutions might fail. True, QE could encourage market participants to take on more risk if they believed short-term interest rates would remain at almost zero for a long time, but the Fed has been clear that short-term rates will have to rise eventually, even if they remain low for a few more years. In addition, the Dodd-Frank Act created a Financial Stability Oversight Council with the power to stop banks and other institutions from engaging in activities that pose a systemic risk, such as taking on excessive leverage. Regulation, not higher interest rates, is the right way to control risk.

Misconception No. 5: QE and the ultralow interest rates that go with it remove the incentive for banks to lend and thus may harm the recovery.

— This confuses the level of interest rates with the spread between deposit and lending rates. The Fed in effect controls bank deposit rates, but it has no control over the spread banks charge when they lend. It’s the spread that provides the incentive for bank lending. Fed policy to keep deposit rates low has no effect on the spread.

Misconception No. 6: QE is going to cause high inflation.

— QE critics have been sounding this alarm for more than four years, but inflation has actually moved down. At some point the Fed will need to terminate QE and begin to raise interest rates to prevent inflation from exceeding its target to a significant extent. It’s not possible for the Fed to achieve both of its targets of maximum employment and 2 percent inflation precisely and continuously. Shocks and unforeseen events are always happening, and the lag between Fed policy and its effects on employment and inflation is fairly long. But there’s just as much chance of undershooting inflation as there is of overshooting inflation.

In the difficult conditions that prevailed after the crash, QE was the right policy, and it still is.

(Joseph E. Gagnon is a senior fellow at the Peterson Institute for International Economics.)

To contact the writer of this article: Joseph Gagnon at jgagnon@piie.com.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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