Wheelies on the Yield Curve:  Inequality, Disintermediation and the Hazards of New QE

By Karen Petrou

Starting with our very first EconomicEquality blog post, we demonstrated the direct link between quantitative easing (QE) and the sharp rise in U.S. wealth inequality that differentiates this recovery from all that came before.  QE exacerbates inequality because, combined with post-crisis rules and ultra-low rates, it creates a market dynamic in which banks hold huge excess-reserve balances instead of making equality-essential loans and markets relentlessly chase yield, increasing equity valuations and driving credit to borrowers such as highly-leveraged companies.  In 2019, the Fed bulked up its portfolio in what is now known as QE-lite in hopes of rescuing the repo market, reinvigorating sputtering equity markets no matter the Fed’s ongoing insistence that this round of portfolio increases isn’t QE.

According to the Wall Street Journal, the Fed is now seriously considering yet another QE it hopes will fix the problems all the others have failed to resolve.  Eschewing the now-discredited “QE” moniker, this is to be called “yield-curve control.”  But, it doesn’t matter what end of which curve the Fed tries to control for which of its many purposes:  until it realizes that the basic engine of U.S. financial intermediation is broken, monetary-policy transmission will do no more than make the rich still wealthier and the Fed even more perplexed. 

The Yield-Curve Cure

As Fed Gov. Brainard explains it, yield-curve control would begin when the Fed wants to drop rates to spur recovery but short-term rates are below the effective lower bound (ELB).  ELB is somewhere near zero, a level to which the Fed is uncomfortably close because of the very low neutral rates defining the post-crisis period.  The neutral rate is the one at which growth neither increases nor drops assuming 2% inflation.  With the neutral rate at around 2% and inflation touching that same level, it’s very easy for the Fed to hit zero and thus go negative in nominal as well as real terms unless it comes up with Plan B – enter yield-curve control.

When or if called upon, yield-curve control – please, not QE! – would cap Treasury securities at the short-to-medium end of the maturity spectrum, combining with effective forward guidance (good luck) to send accommodative rates through the maturities the Fed believes most important to households and businesses in terms of the debt they incur.  Under acute stress, the Fed might also cap yields on ten- year Treasuries, maintaining these caps unless or until inflation hits 2% and employment is “full” for at least a year.  Although yield-curve caps are described as a temporary, ultra-accommodative construct, it’s clear that they could in fact quickly define bond markets and thereby the financial world.

In her detailed description of new QE, Gov. Brainard notes almost in passing the risk of sending financial markets into a paroxysm of yield-chasing across the entire rate spectrum.  Her cure for this is a counter-cyclical capital charge, a response predicated like the rest of this proposal on the belief – for it’s no more than that – that banks drive credit markets, making it thus possible for the Fed through banks not just to alter the macroeconomy, but also to curtail yield-chasing.

Why New QE Won’t Work Any Better Than Old QE

Although the Fed eschews the QE label for both its repo rescue and Plan B, the mechanism of each of its huge market interventions is identical:  the Fed buys Treasury obligations at preferred maturities from banks, hoping that they will use the funds to suit monetary policy by making loans to repo counterparties in QE lite or to households and businesses in old QE and yield-curve controls.  In fact, banks took the money and recycled it back into excess reserves or invested it in Treasury securities or the assets needed for syndicated and secondary markets, proprietary trading, credit-card lending, and the other activities needed to boost return on equity in the post-crisis regulatory regime Although not all banks do all this, virtually all big banks do it and, since the U.S. banking market is heavily concentrated in very big banks, big banks are all that matter in terms of monetary-policy transmission.

Who then might do the lending the Fed hopes to stimulate with its QEs?  In its most recent assessment of the U.S. credit market, the Financial Stability Board found that U.S. banks now hold just 21% of U.S. financial assets.  Because the Fed buys Treasuries largely from banks, QE remains premised on the expectation that banks are the engines of U.S. financial intermediation, but data make clear that this is no longer the case.  Nonbanks may well lend in response to lower rates, but to whom for what will not follow traditional intermediation patterns nor have the same macroeconomic improvement results because nonbanks are very different than banks in terms of the markets they serve, the portfolios they hold, and the maturities of debt they are willing to absorb.

The Inequality Effect

Another truth of post-crisis America is that most U.S. households have more debt than they now can handle, let alone securely honor under stress.  As we noted in our last blog post, millennials – those most likely to increase consumer spending or buy a house – now have student debt in excess of 100% of income; for low-income millennials, this number is a stunning 372%.  As we also detailed, wealthier households generally borrow little and are insensitive to rate changes; average Americans borrow so much that more is surely not to their or the economy’s long-term good – the most recent Fed data show that non-mortgage debt for those in the bottom half of the U.S. wealth distribution stands at 166% of the durable goods they own.  Clearly, borrowing more to fuel more consumption would lead to still more unaffordable debt even if lower-income households got debt at lower rates – which they don’t.

Who Rides the Yield Curve

It thus seems most likely that yield-curve controls would spark still more equity-market records, further increasing the wealth of the one percent along with stoking more financial-stability risk.  Theoretically, longer-maturity Treasury purchases would affect the longer end of the interest-rate maturity spectrum and thus directly reduce automobile, mortgage, and other debt costs.  However, all this lower-cost debt would do is make low-, moderate-, and middle-income consumers still more indebted.  If households fail to heed the yield curve’s siren song, they will be better off, but the Fed will be back in its old perplexity, wondering why massive monetary-policy stimulus has negligible or even counter-productive macroeconomic impact.

Leave a comment