When and How to Exit Quantitave Easing
This is a very math intensive paper (click the link above for the full text) but the plumbing for the argument is less important than the main conclusions. QE works best when it’s applied in size and swiftly. The model developed in this paper by Professor Yi Wen, assistant vice president and economist at the Federal Reserve Bank of St. Louis and professor of economics in the School of Economics and Management at Tsinghua University, though shows something which is now more relevant to practitioners i.e. the best way out of QE is by a quick rip of the plaster.
As Professor Wen puts it ‘..it is optimal for the exit to be completely unanticipated by the public to preserve the maximum gains..’, moreover ‘..once the exit starts, it is better for it to be quick rather than gradual. Accordingly, it would be a mistake for the Fed to pre-announce or discuss in advance the timing of an exit from QE soon after it was implemented;..’.
He further observes ‘..QE works by pushing more creditors to become debtors, which in turn increases the total demand for loans but decreases the average efficiency of loans.’ and therefore ‘..an exit that is too late may also damage the economy because highly persistent (or permanent) QE promotes risk-taking behavior that is too intense..’. Sound familiar?
I’ve no doubt Chairman Yellen will have perused this text and Friday’s unemployment data from the US will have only further stimulated exit discussions. Brace then for a short sharp shock? That it seems would be the right, if temporarily uncomfortable, thing for markets.
Ouch!?
Happy Sunday.