SHOVE HARD and any group can be sorted into contrasting stereotypes: larks and owls; thinkers and doers; conservatives and progressives. Shove again (or simply stir), and you have the makings of a clash. There is a culture war of this kind even in finance. The two bickering tribes are economists and practitioners, such as traders and fund managers. Economists use formal models based on theory. They are rigorous, sometimes to the point of pedantry. Practitioners’ thinking is looser and more intuitive.
The battleground, invariably, is monetary policy and its effects. To outsiders their latest spat—over whether the Federal Reserve’s large-scale purchases of Treasury bills since October counts as a stealthy revival of quantitative easing (QE)—seems obscure. Yet it is part of a broader question that has important implications. For a vocal group of practitioners, central-bank policy has grossly distorted financial markets for a decade. For central bankers and their economist outriders, asset prices are a sideshow.
Who is right? Everybody likes to think they exhibit the best attributes of both schools—the rigour of the economist and the market-smarts of the practitioner. In fact they may borrow the worst habits from each. So, allow Buttonwood to walk into the trap that has been set for him: both camps are wrong.
There is certainly no love lost. For economists, a lot of market talk is shallow and naive. A decade ago a charge heard mainly from practitioners was that QE would lead to hyperinflation. The context seemed not to matter: that QE was pushing against powerful deflationary forces; that the huge increase in central-bank reserves met a deep need in financial markets for safe and liquid assets. Central bankers and economists have not been forgiven for getting that one right. Yet it also the case that a lot of central-bank speak is disingenuous. One of the many talents of Mario Draghi, the former head of the European Central Bank, was to keep a straight face whenever he claimed the sole aim of the ECB’s bond-buying programme was to meet its inflation mandate. Why, you would be a fool to think that capping borrowing costs for indebted euro-zone countries, or devaluing the euro, was the goal.
Mr Draghi is excused, because his policies kept the euro zone intact. But the slipperiness of the Fed is a harder for practitioners to stomach. The roots of their latest spat go back to the end of 2017, when the Fed began to reverse QE. It was keen to put the process on autopilot, shedding so many bonds from its balance-sheet each month. This would be plain sailing, it said. Many practitioners were unconvinced. The markets had got used to functioning with ample central-bank liquidity. Sure enough, last September, money markets were suddenly short of cash. Overnight interest rates spiked. The Fed responded by liberally lending overnight cash. It has since bought truckloads of T-bills. Its balance-sheet, which had shrunk from $ 4.5trn to $ 3.8trn, has been expanding again ever since. Reserves are up, shrieked the practitioners. QE is back!
Case closed? Actually, no. The Fed has not admitted it screwed things up, which is galling. But it is nevertheless quite correct that the remedy it has fixed on is not QE. When the Fed adopted the policy after the financial crisis, it had run out of room to cut short-term interest rates, and so decided to drive long-term interest rates down by buying longer-dated bonds. The goal was to extend the stimulative effect of monetary policy by depressing the term premium—the reward investors get for holding long-term bonds instead of a series of short-term bills. In essence, it was a swap of cash for assets. This is very different from what the Fed is now doing. It is essentially swapping cash (central-bank reserves) for its closest substitute (T-bills) in order to keep the Fed’s key policy instrument (short-term interest rates) where it wants it to be. This is monetary policy as described in textbooks. It is not QE by the back door.
The practitioners are paying the Fed a strange compliment. They attribute an almost mystical quality to the size of its balance-sheet. In fact central banks are mostly responding to events, not shaping them. Despite some extraordinary monetary loosening, inflation has hardly budged. In their own peculiar ways, practitioners and economists are anxious about what this long period of low interest rates might eventually entail. The economists deal with the uncertainty by clinging to their models; the market types by trashing the economists. QE or not QE is not really the question.
