No QE Please. Thank You.

My good friend Feyi, also know as @DoubleEph wrote an interesting piece about a potential way to reduce interest rates in response to El-Rufai’s threat to banks. You know how these politicians always want banks to reduce interest rates without understanding why the rates are high in the first place. Feyi suggests using QE to reduce interest rates indirectly by printing money (electronically?) to buy up privately held government securities. This he argues would help reduce the risk-free rate which banks and others can earn which should reduce the interest rates that folks like you and me and other businesses have to pay when getting money from banks. I think this is a really bad idea but first a bit of context to understand what QE actually was from a monetary policy perspective and why QE cannot be used in out context.

Real GDP vs 3% trend
The graph above is a time series of US Real GDP between 1966 and 2013. Two things stand out. First there has been an average trend growth of GDP, somewhere around 3% per year. According to economists, this trend growth is typically determined by the real inputs into economic activity such as how fast your population is growing, or improvements in productivity or institutional quality and so on. This is commonly called the natural rate of output. However actual GDP tends to fluctuate around that trend. Sometimes GDP grows at a faster rate than the natural rate while sometime it grows slower than the natural rate. If GDP is higher than the natural rate them we have a positive output gap while if GDP is lower than the natural rate then we have a negative output gap.

 

Business Cycle
Why is this important? Its easy to understand why negative output gaps are undesirable. Lower than potential output implies there is room for improvement. A positive output gap is however also just as bad. Besides theoretically leading to higher inflation, positive output gaps typically result in recessions with the recession deeper if the prior positive output gaps are larger. Of course the reverse is also the case, negative output gaps tend to be followed by significant rallies all things being equal. But these booms and busts and recession and rallies are costly. Indeed in the long run the economy is better off if there are no booms or busts but just a steady trot. This is the foundation of monetary policy; a tool to smoothen the economy. Monetary policy authorities raise interest rates if they believe there is a positive output gap and lower it if they believe there is a negative output gap, while keep an eye out for inflation.

In reality there are lots of complication though. For example, to know if there is a positive or negative output gap you have to observe the natural rate of output. But you can’t observe the natural rate of output, you can only observe actual output, actual GDP. Estimating the output gap is one of the biggest topics in economics. Fortunately sometimes it is easy to tell if you are in a negative of positive output gap. For example if you observe that your economy starts growing at 8% when you usually grow at 2% and you can’t really pin it down to any structural changes then you can guess you have a positive output gap. Raise rates to cool hings down. On the other hand if you suddenly find yourself in a deep recession when nothing really happened then you can lower rates to boost things. There are of course other costs to lowering and raising rates, most of which have to do with inflation and exchange rates.

Can you use monetary policy to change the natural rate of output? The short answer is no. The long answer is also no. Why? Because in the long run money is really just paper. Although you can use monetary policy to make things more difficult but that’s a story for another day.

 

Back to the main topic: QE. What was QE? The US was in a recession that threatened to get even deeper. Recall in a recession you can safely assume that you have a negative output gap. The response to a recession is off course to lower rates and stimulate the economy. Unfortunately target interest rate was already at almost zero. This near zero interest rate combined with inflation that was almost zero at the time implied that unconventional action was necessary. Such as pumping cash into the system by buying up debt instruments. And of course more supply of funds should lower interest rates, or increase demand, which should  boost output back towards in natural rate. The UK faced with a similar dilemma of close to zero interest rates and reasonably low inflation used the same type of unconventional policy to boost the economy back to the natural rate.

The important point is to understand the context in which QE was used. It was used not to engineer long-term growth but to get growth back to its natural rate. This should help you understand all the talk about unwinding QE. Most believe that the US is back to its natural rate and not unwinding might imply movement to a positive output gap territory which is a problem on it own. But anyway.

So should we consider using some form of QE in Nigeria to boost economic activity aka output? The answer depends on if we are in negative output gap territory. Given the real fundamentals of the economy, the level of human capital, the infrastructure constraints, the institutional issues, the realities in the crude oil market, are we growing slower than we should be?  I would say no. I think we are growing as we should be given the real conditions. Maybe even faster. Using QE type monetary policy under such conditions would only imply a short-term boost followed by and even by bigger pain when the easing bubble pops. Which sounds like something politician who expect to leave office before the pain comes would love. Thankfully we have a relatively independent central bank that can resist such. We do don’t we? We don’t need short term boosts, we need structural change in the natural rate itself. A change of direction as it were. QE cannot achieve this and will probably inhibit it.

This doesn’t mean that lowering interest rates should not be an objective. It should be but in way that is sustainable. For example as Feyi points out, one of the larger reasons why interest rates are high is because of government borrowing. The famous crowding out phenomenon. If government takes a big chunk of loanable funds then the rest of you have to compete for the remainder, which translates into higher interest rates. If the oil industry, no thanks to its government risk backed supply contracts, takes another chunk then the rest of the economy has to compete even more for the remaining funds, which again translates to even higher interest rates. The government limiting its domestic borrowing should therefore translate into lower rates for every one else. Getting rid of those risk free government backed import-fuel-&-we-pay-differential oil industry deals should also help.

Another alternative is to attract foreign money into the domestic market. Getting foreigners to bring their savings should lower interest rates. Maybe by getting foreigners to buy up tradeable domestic debt such as government bonds. Increased supply of loanable funds into the economy should imply lower interest rates. JP Morgan who? FX restrictions what?

Another controversial alternative is to impose a tax on long-term foreign currency denominated savings. Think about if for a second. If you take your N1m and put in a bank you are increasing loanable funds because your bank can give part of it out as a loan. If you stick $5000 in the bank, then it can’t be loaned out. Because our local banks can’t give out foreign currency loans, at least not to the domestic economy. Please correct me if I’m wrong. So dis-incentivizing long-term foreign currency savings should lead to more Naira savings which should  increase the loanable funds which should lower rates.

Then there is the risk factor. Nigeria is a very risky economy both internally and externally. Figuring out how to reduce risk should lead to lower rates too. Easier said that done though.

See there are many things which could lead to lower interest rates and which do not imply the central bank printing money in some QE copy copy type exercise. We just need the political will to do some.

This post was written in a hurry so apologies for any typos. Questions welcome as always.

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7 thoughts on “No QE Please. Thank You.

  1. Nice one. I think we definitely need QE but I don’t think it can help reduce interest rates by itself. I think:

    1. QE is unlikely to create asset bubbles in Nigeria.
    2. It directly solves the problem of government crowding out private sector.
    3. It will bring down government bond yields.
    4. We need a short term boost to counter the slowdown in addition to the long term structural changes.

    Keep in mind that there is still lots of scope for us to converge with the UK/US on a GDP/capita basis and so I don’t think output gaps are a major concern right now. We need growth, period.

    CBN will need to reduce the MPR in addition to undertaking QE in order to reduce interest rates to the private sector. Otherwise interest rates to the private sector will not come down.

    Cheers.

  2. Sound analysis. … This proclivity to “copy copy” by Nigeria needs to be curtailed. I think you covered all the angles and especially talked about the risky Nigerian environment. QE may have worked for the U.S. where government data is roundly “clean” for citizens and businesses but in Nigeria we don’t know for sure anything. Too many unknowns

  3. Good one.. I had to go read Feyi’s post.. There’s no argument for QE Important question is what is FG funding with its borrowings? My answer is subsidy. People don’t get the damage subsidies are doing to the Nigerian economy.
    And banks lend FCY.. As far as borrower can show proof of FCY receivables.

    1. Nigeria’s government borrowing from 2008 till date has been for only 2 reasons; recurrent expenditure (elections & salaries) & personal/cabal usage. Even NOI had to shut down Bond & T.Bill auctions in late 2013

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