In 2008, when the Federal Reserve resorted to the radical step of quantitative easing to combat the Global Financial Crisis, few would have imagined that more than a decade later the policy would still not have been unwound. The practice of purchasing mortgage-backed securities and US Treasuries for freshly conjured up electronic money was supposed to be a temporary measure, after the conventional central bank tool of short term interest manipulation had run out of firepower at the zero bound. The first programme was followed by two more and took the Fed’s balance sheet from less than $1trn to around $4.5trn – equivalent to almost a quarter of US GDP. In September 2017, then Fed Chairwoman Janet Yellen finally announced the tentative start to the process of unwinding the programme, in line with the original intention to scale back to balance sheet to pre-QE levels. But less than two years later, On 20th March 2019, her successor Jerome Powell announced a halt to the balance sheet reduction later in the year. The announcement came as the chairman also declared that there would be no more interest rate hikes this year, following up on January’s announcement that the previous intention to raise rates by four times 25bps in 2019 was being put on hold.
What has caused this apparent capitulation by the Federal Reserve? The weak end to 2018 in US equity markets coupled with a disappointing picture for global growth seems to have tipped the scales. President Trump was vocal in his criticism of Powell, asserting pressure on the supposedly independent central bank to be more supportive of the US economy.
But the reality is that there was never any realistic hope of normalizing interest rates and unwinding quantitative easing. What was sold as a cure was no more than morphine, an injection of liquidity into the monetary system which worked to underpin an increasingly debt-fuelled economy but did nothing to address the underlying issues of capital misallocation. As Austrian economic theory explains, the recession that QE was designed to prevent is in fact the cure; as unsustainable activities which flourished during the boom phase fail, resources are allocated to sustainable production to meet actual underlying demand. Without the cleansing effect of recession, the economy cannot recover. Take the morphine of cheap money away and the fault lines reappear, only bigger as the resource misallocation has been allowed to continue. This painful lesson, taught by the Austrian school, is what the Fed should now be learning the hard way.
Of course, this is not the message that will be delivered nor the lesson that will be learned. The Fed is explaining its change of course by data indicating a slowdown in both the US and global economy. The central bank is responding to changes in the business cycle with the tools at its disposal. Business as usual. But cynics would say that not much has changed in recent months, except for wobbles in US equity markets. The Fed has long been concerned that tightening of monetary policy would push the economy back in recession and has been looking for an opportune moment to announce a change of course. The obvious elephant in the room, that rates are still very low and QE has not been unwound, is officially being ignored. But it leaves the Fed with little fire power when the inevitable downturn comes. And that in truth is a blessing. The next recession may rapidly force rates back to zero, leaving QE4 as the next weapon of choice. But after the failed unwind of the previous programmes, more may question whether a repeat is anything other than blatant financing of government deficits by the printing presses with no hope of being unwound. The supposed healing effects on the real economy will be questioned. Once the alchemy of central bank manipulation is shown up, the voices calling for the recession to run its course and a return to sound money may find an audience. The Austrians may finally get their moment.