Full ‘postmortem’ on QE yet to be written – Klaas Knot

A full evaluation of quantitative easing as a monetary policy tool is “yet to be written”, Klaas Knot has said.

Speaking on February 4 at the London School of Economics, the former governor of the Netherlands Bank (DNB) and chair of the Financial Stability Board (FSB) said it was not yet possible to evaluate QE’s effectiveness.

Knot, who spent 14 years on the European Central Bank’s governing council, said the effectiveness of QE depends on its objective. If it is about “bank recapitalisation through the back door, QE is very effective and has been very effective”, he said. But when its aim is to lift inflation from 1% to 2%, the evidence for its utility is “much more questionable”.

He then spoke of Kevin Warsh’s nomination as the next chair of the US Federal Reserve. Knot said Warsh’s views on QE were “clear” and that he was an “excellent technocrat”, a “competent colleague and a relatively orthodox central banker”. This meant the fears within the markets about certain other contenders for the Fed role would be unlikely to materialise under Warsh’s chairmanship.

Knot told Central Banking that he expected co-operation between central banks to remain active even during periods of geopolitical tensions because it was a “brotherhood” and a “community where there is high trust among officials”.

“We’re a little bit farther away from the political processes, the recriminations,” he said. “But for me it is crucially important for an effective conduct of monetary policy that there is co-ordination between, let’s say, the large blocs of the world. And I’m also confident that under the new Fed leadership that will continue to be the case.”

The former DNB governor explained that if fears around the Fed’s continued independence were to materialise under Warsh, it would result in a weaker dollar and higher long-term interest rates thanks to a rising inflation risk premium.

2007–12: Age of crises

Knot used his speech to reflect on his experience of the global financial crisis and the subsequent eurozone sovereign debt crisis.

He said that, in theory, European monetary union had been founded on the principles of the stability and growth pact. This set upper limits of 3% on member states’ budget deficits and 60% on their debt-to-GDP ratios to enforce “market discipline” on fiscal authorities. However, Knot said this was not how things had worked out in reality.

“Shortly before the crisis, Greek bonds were trading at five basis points over German Bunds,” he said. “Then, when all of a sudden markets did pay attention to heterogeneity, it became a destructive, self-fulfilling spiral.” This had proved “so destructive that there was no policy adjustment anymore possible to deal with these developments”.

The original architecture of monetary union had been “woefully inadequate” to deal with a crisis of the kind that occurred in 2012, he said. There had been no lender of last resort, no backstop and no European stability mechanism, and bank supervision was still the domain of national authorities.

Another lesson from the crisis was that the “no bailouts clause” had not worked because capital flight was too quick and spread risks across the eurozone. This, Knot said, had made the enforcement of the clause “unrealistic”.

The former DNB president said there had been an inherent risk for the eurozone from the fact that debt issuance still happened at a national level while monetary policy was set for the bloc as a whole. Resolving this – and the ECB taking on “some form” of lender-of-last-resort role – had ultimately been the only way to resolve the 2012 debt crisis.

He recalled that some members of the ECB governing council were surprised when the bank’s then president, Mario Draghi, said it would do “whatever it takes” to protect the euro, but that they had quickly coalesced around the statement. The announcement, and the quick design and announcement of the instrument – just like that of the “transmission protection instrument” – had helped to calm markets.

2013–20: Experiences at the effective lower bound

Knot said that between 2013 and 2020, monetary policy and fiscal policy had counteracted each other, and this had made the former ineffective.

“If you have 19 or 20 countries all individually consolidating their public finances, then the aggregation of that is a eurozone fiscal stance which is hugely contractionary,” he said. The former DNB president added that the ECB had been hoping that fiscal authorities would implement expansionary policies following the eurozone debt crisis. Yet the bloc had been simultaneously experiencing “hyperglobalisation”, which ECB staff saw to be a “slow-moving positive supply shock”.

These two factors – fiscal consolidation and hyperglobalisation – meant the bank had found itself fighting two exogenous deflationary factors.

The bank had experimented with forward guidance, long-term refinancing operations and asset purchases, Knot recalled. However, he said monetary policy was less effective when constrained by the lower bound than it was when interest rates were high.

He suggested the eurozone’s lack of a shared fiscal policy had been a problem, as few policy-makers really felt “responsible” for the bloc’s fiscal stance.

A key takeaway from this period, he explained, was that reducing borrowing costs when they were already very low would not provide governments with “much bang for [their] buck” in terms of expenditure. QE had also come with side-effects. These included weaker discipline for governments when it came to fiscal consolidation, “misallocation leading to mediocre productivity and growth in the real economy”, and “massive asset price inflation”.

QE had also led to central bank losses at a time when the public finances were under stress, he noted, referring to the fact that many monetary authorities had booked losses when inflation spiked and they were forced to hike rates.

2020-21: Dealing with the pandemic

The onset of Covid-19 in early 2020 had also been an “unprecedented shock”, Knot said. The only comparable experience had been the 1918 ‘Spanish’ flu epidemic, and there had been no economic data or policy-maker experience for the ECB to learn from.

At this point, inflation was still running below target, he recalled, but then the pandemic created negative demand and supply shocks. These typically had opposite effects on inflation, so the ECB had to figure out which of the two would dominate.

The bank thought the demand shock was more instantaneous and that inflation would therefore drift even lower, Knot recalled. It consequently began its pandemic emergency purchase programme, which stabilised the markets and returned credit spreads to a level closer to the ECB’s expectations.

The “reopening” of eurozone economies in 2021 had been even trickier for the ECB, he said. This amounted to a “reverse of the initial shock”, and had acted as both a positive demand shock and a positive supply shock – though demand recovered much more quickly than supply. This had caused the initial post-Covid wave of inflation, he noted.

At this time, monetary and fiscal policies were working to enact a concerted stimulus in the eurozone. This had an “enormously strong demand effect”, which led to a second, stronger wave of inflation.

This in turn had led to the famous debate between “team permanent” and “team transitory”, Knot explained. The ECB’s decision to try to look through the demand effect, thinking the supply chain issues would ease, had been wrong in hindsight, he added.

What the ECB – and Europe more broadly – had not been expecting was a second supply shock in February 2022.

“If you look through an initial and first inflation shock, you assume an open risk position – that if you are hit by a second shock, you are toast,” Knot said.

2022–23: Inflationary wave

Russia’s full-scale invasion of Ukraine and the subsequent energy crisis made the ECB realise it was “behind the curve” and had to act, Knot said. He admitted that he was less aware of the “dependencies” between different sectors – such as how energy-intensive fertiliser production was, and how that would translate into spiking food price inflation.

The ECB had also underestimated the second-round effect of inflation and its materialisation in wages, the former DNB president said. Workers had lost purchasing power and, as they renegotiated salaries, service prices replaced energy prices as the largest part of the inflation data puzzle.

At this point, the bond markets were already forward-looking, Knot pointed out, as yields on 10-year government debt were anticipating rates rises months before the ECB first tightened policy in July 2022.

For Knot, the surprise was how “mild” the impact of the tightening cycle proved to be. Few banks had failed – aside from Credit Suisse and some second-tier lenders in the US – which he said was a testament to how effective the post-2008 reforms had been.

Central bank independence had also played a role, he said. The ECB was able to disinflate without “any economic cost”, as unemployment did not rise at all – unlike in the US in the late 1970s and early 1980s, when the “misery index” spiked as Fed chair Paul Volcker hiked rates to battle inflation.

Knot defended the pace of disinflation by saying that the cost to the real economy would have been “much higher” had the ECB hiked rates more aggressively.

He said there had been an issue with the ECB’s models in 2022–23, as they were all showing that inflation would converge to 2% without rate hikes. This explained why the bank had been “so late” to tighten policy.

Knot said he was not a “model basher”, but that it was difficult to predict the inflation effects of a pandemic and a war. The ECB’s models had failed “temporarily” because the bank did not have data to calibrate.