Can QE save economies this time?

The superman of the last crisis, quantitative easing (QE) is back on the policy set.

A return from QE becomes less likely as the credit risk relentlessly piles up.

QE was an effective tool in 2008 when purchasing risk free treasuries helped economies recover. However, extension of QE to riskier assets gambles the tax payer's money.

The QE tools push the Fed to riskier assets as the US economy is stuck in a recession.

Nowadays, central bank policies get complicated even for economists. The superman of the last crisis, quantitative easing (QE) is back on the spot. However, this time, the dose is raised, extending the scope to riskier assets such as stocks and commercial bonds.

The funding rate is the main monetary policy instrument. In a recession, a lower nominal interest rate reduces the real interest rate while inflation expectations are steady. Consumers raise expenditures in a low real interest environment as deferral of spending yields less. However, the interest rate policy is not free of limits. Nominal interest rates cannot go way below zero. Central banks need unconventional monetary policy tools, such as quantitative easing and forward guidance, when pulling the funding rate to zero does not sufficiently stimulate spending.

In fact, unconventional tools also address the same transmission between interest rates and spending. Through massive asset purchase programs, central banks reduce the interest rate of riskier assets. Purchasing risk free 10-year treasuries is not an option in 2020 since their interest rates are already below 1%. The interest rate gap between 10-year treasuries and corporate bonds rise with respect to the risk. The spread rises from 1.7% to 2.9% between AAA and BBB rated commercial securities. Therefore, the Fed is hooked to buy riskier assets as the US economy is stuck in a recession.

As the Fed absorbs riskier assets, financial agencies manufacture even riskier assets. The issuers of riskier assets pay salaries and other expenses through debt. Spending flourishes, hence. In fact, this mechanism is full of wishful thinking. Businesses don't expand their consumption just because they access cheap funds. When quantitative easing was in practice in 2010, the US economy has already recovered from stagnation. Businesses were making investment plans as they foresaw an upward trend in their revenues. Therefore, QE could boost the demand for investment goods. In the middle of the COVID-19 recession, expecting businesses to invest in real goods is not realistic. As expected, they participate in the asset price bubble via purchasing stocks. Quantitative easing thereby inflates prices of assets instead of goods and services.

Meanwhile, surging credit risk due to the issuance of riskier assets exposes financial markets to turbulences as investors are aware of the record-high credit risk. In every financial or economic upheaval, the Fed needs to step up the gear of risk. Similar to narcotics, the dose of QE needs to be raised in every economic or financial upheaval.

QE was an effective tool in 2008 when purchasing risk free treasuries helped economies recover. Nonetheless, extension of QE into riskier assets gambles the tax payer's money. A return from QE becomes less likely as the credit risk relentlessly piles up.