Since the financial crisis of 2007-2008, central banks in the developed world have played a major role in piloting economies through uncertain times. After having relied on traditional monetary instruments to decrease short-term interest rates near zero, central banks have rapidly pushed the use of more unconventional techniques such as Quantitative Easing (QE) in order to boost their respective economies. These unconventional techniques have, in turn, induced major market distortions and a discrepancy between the course of the “real” economy and the course of financial markets. The decision of Ms Janet Yellen, head of the US Federal reserve, to lift up interest rates at the end of 2015 and the announcement of further interest rates increase are signs that this era of monetary easing might be over but at what price?

The role of central banks since the financial crisis of 2008

Janet Yellen, current head of the US Federal reserve
Janet Yellen, current head of the US Federal reserve

Our generation remembers well the financial crisis of 2008 that led to a major economic recession whose effects can still be felt today. However, the Great Depression of the 1930s that followed the financial crash of 1929 was far more destructive by its magnitude. At that time, the US Federal Reserve decided to maintain a restrictive monetary policy in the middle of the financial crisis, instead of providing more liquidity to the economy. By doing so, the central bank created an environment of severe credit tightening that led many banks to bankruptcy. According to economist Milton Friedman, this was the root cause of the economic depression of the 1930s.

Some eighty years after, in 2008, central banks and the US Federal Reserve in particular seemed to have remembered the painful experience from the 1930s. Soon after the collapse of Lehman Brothers, central banks in the developed world took strong initiatives in order to boost their ailing economies. Interest rates dropped near zero and the financial system was literally flooded with liquidities. Whereas central banks should, in theory, be independent from political cycles, central banks and governments started working hand in hand in the US and Europe in order to make their way through these difficult times.

Very quickly though, given the seriousness of the situation, central banks felt short of traditional instruments to sustain their economies. Consequently, they had to resort to more unconventional ways such as intervening directly in specific markets by buying assets in large scale in order to restore confidence. In the US, for instance, the Federal Reserve started buying mortgage-backed securities as from March 2009 for about $2 trillion in total, inaugurating three rounds of “Quantitative easing”. In Europe, the reader will maybe remember January 2015 when Mario Draghi, head of the European Central Bank (ECB), announced an “expanded asset purchase programme” that would total about $1 trillion in September 2016. The rationale behind these unconventional policies is easy to understand: When a market is ailing and lacks liquidity and confidence, the central bank will intervene by buying large amounts of assets, adding liquidity in these markets and, thus, restoring confidence. The main issue with QE, though, is that it leads to significant market distortions and that markets get addicted to it. Once markets have got accustomed to QE, it is very difficult to stop it without triggering a financial downturn.

Why QE creates a vicious cycle

Mr Alberto Gallo, head of macro credit research at Royal Bank of Scotland (RBS), described very well the vicious cycle induced by “infinite” monetary policy and QE. By resorting to QE, central banks distort the price in existing markets as assets that are worth quasi nothing according to market standards are suddenly bought by central banks at unrealistic prices. In a market economy where prices should be “naturally” determined by the law of supply and demand, this unconventional policy creates asset bubbles (since assets are worth more than what they would be worth in the absence of QE), arbitrary wealth redistribution and resource misallocations. All these factors, in turn, lead to a higher level of inequality since the liquidities injected by central banks do not find their way in the “real” economy, most of the time, but end up feeding banks and financial institutions. Also, resource misallocation leads to a lower level of productivity. Finally, asset bubbles ultimately lead to financial booms and busts. As a result, a discrepancy emerges between the state of the financial markets and the state of the real economy, one even contradicting the other. In the absence of long-term political reforms or fiscal stimulus, central banks have no choice but doing more QE and more monetary easing in order to keep the economy moving further in an artificial way. The vicious cycle goes on and on.

Why QE has become an addiction

Actually, monetary easing has become an addiction for developed economies for the reasons already cited above. By injecting billions of liquidities and by intervening directly in specific markets to restore confidence, central banks have improved the performance of financial markets but only superficially. Also, the problem is that the market price of goods and services got completely distorted by the intervention of central banks, making any fundamental or technical analysis irrelevant for investors. In a nutshell, infinite QE and infinite monetary policy make the state of an economy appear better than what it actually is, which can also explain why financial markets can grow whereas real macroeconomic data such as unemployment rate and wage growth might be struggling.

Towards the end of infinite QE

By definition, a vicious cycle only gets worse and worse until it becomes unsustainable and explodes. In the case of infinite QE, central banks in developed economies and the Federal Reserve in particular eroded their credibility during these last couple of years by regularly promising the end of monetary stimulus and doing actually exactly the opposite, which is even more monetary stimulus. At a certain time, financial markets would stop believing the announcements of central banks, making any monetary policy useless as it would only have a moderate or non-existent impact on the markets. In such a situation, central banks would lose control of the economies they should regulate, investors and other market participants would realize that most market prices are actually overestimated and will massively adjust their expectations accordingly, leading to a major “market readjustment”, i.e. falling prices, economic recession and… central banks doing more QE.

In order to impede a “doom and gloom” scenario and to put the markets back on their own feet, central banks have no choice today but to move away from the easing monetary policy they introduced as from 2008. Readjustments can be tough in the short run as financial markets will have to stop being addicted to QE and prices will automatically adapt in order to better reflect the assets’ real “fair” value, which will also induce more market volatility. This is however the price to pay. According to us, central banks and the US Federal Reserve in particular took a lot of positive initiatives that allowed avoiding a remake of the Great Depression but they now have to step back, which is easier said than done.

Photo credit:  José Luis Sánchez Mesa;

Photo credit:  IMF Staff Photograph/Stephen Jaffe;


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