Ultra Easy Monetary Policy

2012 September 9
by SJ Leeds

Okay, so I’ve had two bad weeks of not writing much.  And…I have a difficult four weeks ahead.  But, I’m really hoping to write more.  In addition, today’s blog is an important one — it’s really something that may help you to think about the future.


Today, I want to share a paper with you that a lot of people are talking about – and I’m not talking about just my egghead friends.  The paper is titled, “Ultra Easy Monetary Policy and the Law of Unintended Consequences.”  It was written by William White – a career central banker (with the Bank of England, Bank of Canada and the BIS).


As Mr. White makes clear in his paper, your starting point has to be that we have no idea what will happen in the future.  If our models worked, the financial crisis would have never happened.  So, we have no idea what long-term consequences will result from the “ultra easy” monetary policy that we’re seeing throughout the world.  That’s why we need to think about what could happen.


Here’s what I want you to have:

1. a link to the paper – the paper is long (~45 pages) (or you can get the paper on the Dallas Federal Reserve bank website)


2. my summary of the paper (this is probably a 20 – 30 minute read)


3. my blog…a quick summary of some of the things that could happen as a result of easy monetary policy.  This is NOT to say that all of these things will happen.  Rather these are things to think about.  Almost all of them come from the White paper.  (But, a few are ideas that I added.)


What are the Possible Problems or Ramifications of Ultra Easy Monetary Policy?

  1. Large-scale asset purchases may lose their impact.  In addition, this strategy may become ineffective because it may not impact longer-term rates.
  2. Mortgage rates may not be as responsive to easy monetary policy.
  3. Low Fed Funds rate could eventually be offset by rising corporate spreads.
  4. If inflation expectations fall, the real rate can remain high (even if the nominal rate is low).
  5. If the goal of low rates is to devalue the currency, this is not something that all countries can do.
  6. Low rates in advanced markets put pressure on emerging markets to take risky action.  (This is because emerging markets don’t want their currencies to appreciate relative to the dollar.)
  7. If the goal is to inflate stock prices, these gains may not be sustainable.
  8. Lower rates won’t push home prices back up.
  9. These nonstandard policies are experimental and we have no idea how they’ll turn out.

10. The Japanese tried many of these policies and they’re skeptical of them.  (Many people will tell you that the Japanese started too late and didn’t fix their banks…but the point is that they’re skeptical.)

11. Even if these lower rates do increase spending, we’re just pushing this demand forward from a later period.

12. The message that the Fed action is “unprecedented” may signal desperation and ultimately hurt consumer confidence.

13. While lower rates may increase spending, now you have to save more to reach your long-term goals.

14. Low rates mean more income for debtors and less income for creditors.

15. Lower rates do not create wealth.

16. Lower rates are unlikely to change the long-term trend of shrinking investment (as a percentage of GDP).

17. Low rates cannot make up for the high level of uncertainty that exists.

18. Low rates may have increased commodity prices (depressing investment).

19. Low rates increase pension liabilities.

20. It may be inflationary to set interest rates below the growth rate.

21. If we do start to have inflation, we’re going to have to raise rates (after convincing consumers and investors that low rates are crucial to recovery).

22. Low rates could lead to bad investment decisions (overinvestment in industries).  This could eventually lead to a collapse in profits.

23. Low rates may lead to lower savings.

24. Low rates may allow debt to accumulate.

25. Low rates have prevented the “creative destruction” that is necessary.  In other words, we always bail everyone out.

26. Constantly responding to crises by lowering rates may lead to “serial bubbles” that will eventually lead to a really serious downturn.

27. Low rates encourage lenders to take more risks.  Examples include subprime loans and SIVs.

28. Low rates encourage investors to use leverage (adding risk to system).

29. Low rates may result in credit expansion that far surpasses income growth.

30. Low rates may result in less desire to loan long-term.

31. Promises that low rates will continue may slow consumers from borrowing.  (They know that they can wait and still get low rates in the future.)

32. Low rates encourage debt at a time when we’re trying to deleverage.

33. Low rates may make money market funds unprofitable.

34. Low rates hurt insurance companies (which we rely on to be able to transfer risk).  This is because their investment income drops (so they either have to raise premiums or exit the business).

35. Low rates may lead investors to reach for yield (i.e., take too much risk).

36. Low rates may result in players exiting the market (believing that they’re not being compensated for risk).  This may leave the Fed as the lender of last resort.

37. If we move rates lower through Fed purchases, we lose confidence in market prices.  (In other words, what would Treasury yields be right now if the Fed wasn’t a huge buyer?)

38. When the Fed buys large amounts of government debt, we worry that there are no real buyers for our debt.

39. In an effort to lower rates, central banks start to take more risk by buying riskier securities (such as longer-term bonds).

40. Extreme action by the central bank could result in a loss of independence.  (In other words, it gives politicians a stronger argument against the Fed.)

41. Low rates could encourage the government to borrow short-term (increasing refinancing risk).  (In reality, we haven’t seen this…the U.S. has been borrowing longer-term.)

42. Low rates could create false confidence in the sustainability of our fiscal situation.  In other words, our interest is expense is extremely low right now – so we don’t feel the true repercussions of all of our debt.

43. It may be very difficult (for the central banks) to exit these low rate positions.

44. Low rates may further income inequality.  The argument is that the low rates help those with good credit more than the people who are underwater in their home.


Have a great week.

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