HAMISH MCRAE: US Federal Reserve war on quantitative easing

The world’s central bankers, led by the US Federal Reserve, are starting to see sense. Quantitative easing – that ugly expression for creating more money and pumping it into the economy – is to be replaced by quantitative tightening. 

Instead of putting more money in, the Fed will start sucking it back out. Thus QT replaces QE, and about time too. 

Last week one of the Fed’s governors, Lael Brainard, said that it could start cutting its balance sheet next month and would do so at ‘a rapid pace’. Shrinking the balance sheet is another way of saying that the Fed will start QT. 

She also warned that interest rates might increase in increments of more than 0.25 per cent. These two points were confirmed by minutes the next day, which also carried a strong hint that rates would go up by 0.5 per cent in May. 

This is really big stuff. It means that the policy of QE is dead. What the Fed does will have a profound influence on policy here in the UK and in Europe. On Thursday Huw Pill, chief economist at the Bank of England, gave a speech in which he said that QE might be the wrong way of tackling future market disruption. And while whatever the European Central Bank will do remains a bit of a mystery, Goldman Sachs has just put out a note saying it thinks the ECB will start increasing interest rates much sooner than the markets expect, perhaps as early as July. 

This switch of policy has already started to move the bond markets. 

For most of us, what happens to bond yields seems a bit arcane, and they certainly attract much less attention than equity prices or indeed house prices. 

But over the past six weeks there has been a sea change that has swept across the world. At the beginning of March, ten-year US treasuries yielded just over 1.7 per cent. Now the rate is 2.7 per cent. The numbers for ten-year gilts were 1.1 per cent then and now nearly 1.8 per cent. 

As for German ten-year bunds, they were actually negative on March 1 – you paid money, if you were fool enough to do so, to lend to the German government. Now they yield 0.7 per cent, far too low but at least you get something back. 

This is a return to common sense by the global central banking community. Maybe the policy of ultra-low interest rates and QE was necessary after the banking crash of 2008-09, and maybe another bout was justified to ease the world through the disruption of the pandemic. But it was carried on for far too long. 

Because current inflation remained low, they thought they could keep pumping the money in without any problems, and it was true the costs of the policy were not very evident. 

But common sense says that if you print industrial quantities of money, there is a huge danger that this will eventually lead to massive inflation. It happened in the 1970s and it has happened again.

Why did inflation take so long to come through? I don’t think we really know yet, but we do know that the lags in economics can be very long. 

The analogy I like best is to imagine you are filling a bucket with water. You keep pouring water in and everything is fine for a while. Then suddenly the bucket overflows and the kitchen floor is flooded. QE is keeping the taps running. QT is mopping up the mess. 

That mopping up is just beginning and will probably take several years. Eventually we will get back to the normal relationship where interest rates are a little higher than inflation for sound borrowers and quite a lot higher for risky ones. This shift will lead to disruption. Companies that have been kept alive because they have free capital will struggle. 

Countries that are heavily indebted may find they have to devalue – I expect another bout of tensions in the Eurozone. People who are over-borrowed will have to cut back or sell assets.

But this won’t be like the 1970s with double-digit interest rates because as yet inflation has not been allowed to become embedded in the economy. Fortunately, the jobs market remains very strong. 

So while the central bankers are right to be frightened, the fact that they are scared means the rest of us can relax a little. That was the verdict of the markets last week. Share prices were pretty solid, with most major equity markets higher now than before the invasion of Ukraine.

It will be a bumpy old ride back to normality but I for one feel a sense of relief that we have begun it. Well done, the Fed.