QE is becoming a narcotic

Central banks permanently create new money to prevent defaults when they bear the credit risk of commercial securities.

While there is no room for the short-term interest rates, the Fed aims at reducing long-term interest rates. For this purpose, it introduces the unconventional tools, quantitative easing and forward guidance.

After 2020, a balance sheet contraction becomes almost impossible due to the extension of asset purchase programs to the commercial sector.

A central bank can traditionally boost demand by lowering the real interest rate. While the target inflation rate is 2% in most countries, central banks have a narrow corridor to dampen real interest rates.

A central bank cannot pull interest rates way below zero due to negative consequences. As nominal interest rates move below zero, lenders lose from their principles at maturity. To preserve their principle, at some point, savers would withdraw their money from banks. Thereof, below the zero lower bound, central banks are not comfortable while further reducing their funding rates. The most radical negative interest rate experiences of central banks did not surpass -1%.

In the most extreme case, a central bank can lower the real interest rate lowest to -3% while the funding rate is -1% and the expected inflation rate is 2%. In a severe recession such as the one in 2008, the US required a lower real interest rate. While there was no room for the short-term interest rates, the Fed aimed at reducing long-term interest rates. For this purpose, it introduced the unconventional tools, quantitative easing and forward guidance.

Through quantitative easing, the Fed plunged long-term treasury rates by purchasing long-term treasuries. A reduction in treasury rates also decreased the interest rates of commercial securities by enhancing their demand. Through forward guidance, the Fed reduced all types of long-term interest rates by promising to the markets that it would not raise the funding rate for a certain period of time.

In the 2008 global financial crisis, the Fed could boost the economy through unconventional tools at the expense of a record high balance sheet. In 2020, the same tools were exploited once more. However, this time, long-term treasury rates were already around 1%. To dampen the interest rates of all types of securities, the Fed extended its asset purchase programs to municipality and commercial securities. However, the nature of quantitative easing, which requires purchasing in bulks, created an addiction in the markets.

In each asset program, the Fed creates trillions of dollars. As it includes commercial securities and stocks in its balance sheet, price of assets rise due to a higher demand. In this atmosphere, zombie corporations can roll over debt via issuing new debt. Since the Fed has already bought investment grade bonds, investors have no option but to purchase junk bonds of zombie corporations.

Quantitative easing is increasingly rendering a narcotic. In the next financial distress, the investors will run away from a greater amount of assets, which will be riskier than ever. In other words, the Fed will need to buy more risky assets through quantitative easing (QE) to keep markets alive. Thus, the default risk of assets owned by the Fed will surge. The QE story would end when the Fed needs to buy junk bonds to maintain the liquidity in financial markets. Within this trend, shrinking the Fed's balance sheet becomes impossible as doing so will bankrupt zombie businesses which cover a significant portion of commercial debt.

In 2020, quantitative easing does not help the economy recover because households cannot benefit from the Fed's expansion as they cannot issue debt papers other than mortgages. Households largely borrow from banks. Although the Fed lent extensively to the banking sector, banks do not transform the Fed resources into credits while expecting a higher delinquency rate in a recession. In conclusion, the Fed funds does not stimulate demand.

Unprofitable businesses need to be cleared off in good times. If they are kept alive, their collective collapse in a recession creates a burden too heavy for the economy. Banks would not allow a decline in asset prices any time if they could print money. Likewise, central banks don't let businesses fail when they own commercial securities. The Fed thereby could not significantly shrink its balance sheet after 2008.

In the aftermath of COVID-19, a balance sheet contraction becomes almost impossible due to the extension of asset purchase programs to the commercial sector. Thanks to the Fed, the amount of zombie borrowing piles up, further exacerbating the default risk. From this time forth, letting zombie firms fail will be a scary scenario for the Fed since it will impose a financial burden on the Government. The Fed's independence might also be questioned as the assets in its ownership default. This fear necessitates the Fed to speed up QE and not to shrink its balance sheet even in boom times.

In summary, new unconventional tools, which expand the money supply through banks, are required against COVID-19. Banks should remain as the responsible of resource allocation and credit risk management.