Buttonwood

The culture wars between

economists and markets
practitioners
The latest spat is over whether the Fed is doing QE by the
back door

Finance and economicsFeb 6th 2020 edition

Feb 6th 2020

Shove hard and any group can be sorted into contrasting

stereotypes: larks and owls; thinkers and doers;
conservatives and progressives. Shove again (or simply
stir), and you have the makings of a clash. There is a
culture war of this kind even in finance. The two bickering
tribes are economists and practitioners, such as traders and
fund managers. Economists use formal models based on
theory. They are rigorous, sometimes to the point of
pedantry. Practitioners’ thinking is looser and more
intuitive.

The battleground, invariably, is monetary policy and its

effects. To outsiders their latest spat—over whether the
Federal Reserve’s large-scale purchases of Treasury bills
since October counts as a stealthy revival of quantitative
easing (qe)—seems obscure. Yet it is part of a broader
question that has important implications. For a vocal group
of practitioners, central-bank policy has grossly distorted
financial markets for a decade. For central bankers and
their economist outriders, asset prices are a sideshow.

Who is right? Everybody likes to think they exhibit the best

attributes of both schools—the rigour of the economist and
the market-smarts of the practitioner. In fact they may
borrow the worst habits from each. So, allow Buttonwood
to walk into the trap that has been set for him: both camps
are wrong.

There is certainly no love lost. For economists, a lot of

market talk is shallow and naive. A decade ago a charge
heard mainly from practitioners was that qe would lead to
hyperinflation. The context seemed not to matter:
that qe was pushing against powerful deflationary forces;
that the huge increase in central-bank reserves met a deep
need in financial markets for safe and liquid assets. Central
bankers and economists have not been forgiven for getting
that one right. Yet it also the case that a lot of central-bank
speak is disingenuous. One of the many talents of Mario
Draghi, the former head of the European Central Bank, was
to keep a straight face whenever he claimed the sole aim of
the ecb’s bond-buying programme was to meet its inflation
mandate. Why, you would be a fool to think that capping
borrowing costs for indebted euro-zone countries, or
devaluing the euro, was the goal.

Mr Draghi is excused, because his policies kept the euro

zone intact. But the slipperiness of the Fed is a harder for
practitioners to stomach. The roots of their latest spat go
back to the end of 2017, when the Fed began to reverse qe.
It was keen to put the process on autopilot, shedding so
many bonds from its balance-sheet each month. This would
be plain sailing, it said. Many practitioners were
unconvinced. The markets had got used to functioning with
ample central-bank liquidity. Sure enough, last September,
money markets were suddenly short of cash. Overnight
interest rates spiked. The Fed responded by liberally
lending overnight cash. It has since bought truckloads of t-
bills. Its balance-sheet, which had shrunk from $4.5trn to
$3.8trn, has been expanding again ever since. Reserves are
up, shrieked the practitioners. qe is back!

Case closed? Actually, no. The Fed has not admitted it

screwed things up, which is galling. But it is nevertheless
quite correct that the remedy it has fixed on is not qe. When
the Fed adopted the policy after the financial crisis, it had
run out of room to cut short-term interest rates, and so
decided to drive long-term interest rates down by buying
longer-dated bonds. The goal was to extend the stimulative
effect of monetary policy by depressing the term premium
—the reward investors get for holding long-term bonds
instead of a series of short-term bills. In essence, it was a
swap of cash for assets. This is very different from what
the Fed is now doing. It is essentially swapping cash
(central-bank reserves) for its closest substitute (t-bills) in
order to keep the Fed’s key policy instrument (short-term
interest rates) where it wants it to be. This is monetary
policy as described in textbooks. It is not qe by the back
door.

The practitioners are paying the Fed a strange compliment.

They attribute an almost mystical quality to the size of its
balance-sheet. In fact central banks are mostly responding
to events, not shaping them. Despite some extraordinary
monetary loosening, inflation has hardly budged. In their
own peculiar ways, practitioners and economists are
anxious about what this long period of low interest rates
might eventually entail. The economists deal with the
uncertainty by clinging to their models; the market types by
trashing the economists. qe or not qe is not really the
question.