QE3: Their money, our problem
by Virendra Parekh on 04 Oct 2012 4 Comments

The world is going to be inundated with torrents of dollars and euros in the hope that this incessant flood of liquidity will lift the economies of the US and the euro zone out of the morass of low growth, high unemployment, unnerving uncertainties and sagging confidence among consumers and businessmen. If the central bank of a Third World country had attempted a similar move, it would have been condemned as irresponsible and stupid. When resorted to by the US Federal Reserve and the European Central Bank, it is supposed to be hailed as a master stroke of monetary management.


In its latest (third) attempt to re-flate the US economy through quantitative easing i.e. printing money, the US Federal Reserve has announced that it will buy MBS (mortgage-based securities) securities worth $40 billion a month until the outlook for jobs improves substantially. The Fed would also continue to reinvest principal payments from its holdings of agency debt and agency MBS. Effectively, the Fed would be purchasing about $85 billion a month. In addition, the Fed will continue with its Operation Twist (sale of short-term bonds while purchasing longer-term securities) until the end of the year and maintain near zero rates until mid-2015.


Ben Bernanke’s predecessor Alan Greenspan would have been aghast at the thought of a US central banker committing himself publicly to not increasing rates for nearly three years into the future. But the US is living in abnormal times and, therefore, resorting to unorthodox measures.


Please notice that QE3 is a bottomless pit, at least in theory. Fed has tied the scale, timing and quantum of its asset purchase policy to the progress of the economy on a monthly basis, especially the unemployment rate. It has not specified the unemployment rate it is targetting, but its own forecasts suggest the unemployment rate might not fall to 7 per cent even by the end of 2014. Since the long term comfort level of unemployment for Fed is about 6 per cent (if not lower), Fed’s purchases of $40 billion of MBS a month could continue for long.


The bond buying programme is aimed at reviving the housing industry in America which is seen as a significant driver of growth. The Fed has targeted the housing sector so that easy and cheaper finances are made available for home buyers. The intervention in the mortgage-backed security (MBS) market will also provide some relief to banks in whose books such securities are still lying at eroded values.


Something similar has been happening in Europe. The European Central Bank has bought sovereign bonds worth €209 billion since May 2010 through its Securities Markets Programme (SMP). The SMP is now closed and replaced by another bond-buying programme: Outright Monetary Transactions (OMT). The new purchases will be confined to debt with a residual maturity of up to three years. But the crucial feature is: the purchases will be unlimited; in bank-speak, there will be no prior “quantitative limits”. The ECB has not specified yield caps but it is determined to bring yields down from levels that reflect fears of a euro-zone break-up.


The ECB received a shot in the arm after the German constitutional court verdict to support the eurozone bailout with requisite caveats.


The markets across the world predictably responded very positively. The impact of these measures on prices of the long-dated MBS bonds, stocks and commodities has been nothing short of stupendous. In India, the upward movement in stock prices and rupee was aided by the sudden burst of reforms unleashed by the government to achieve a variety of economic and political objectives.


However, before climbing the bullish bandwagon it is important to understand the dynamics involved in the QE operations and assess how successful Fed will be in achieving them.


Experience suggests that this kind of monetary loosening is a short-term solution, much like a band aid on a broken leg. Its positive impact even on financial markets is short-lived. It does not lead to any significant revival of the real economy. Worse, by boosting commodity prices, it makes life harder for lots of other countries.


For Bernanke, it seems as if the last five years did not happen. He still thinks that by mispricing capital and keeping the cost of credit abysmally low, he can make unemployment go down. He has been printing money like crazy, has kept interest rates near zero and yet unemployment in the US is still 8.1 per cent.


What America is witnessing today is something that Japan has been undergoing for the past two decades. Japan has seen zero interest rates and QE programmes that involved purchases not just of Japanese government bonds but also of mortgage and corporate debt and even Index futures. Still, in spite of all this the Japanese stock market is almost a fifth of its peak and the economy chugs along in and out of negative growth territory.


Lord Meghnad Desai tells us that “monetary loosening has not worked in the UK either, though there are claims that without QE the situation would have been much worse. That remains to be tested when the data is revised. As of now, the UK economy has not been doing well at all. The question remains if the ECB will be any more successful with its monetary expansion than the Fed or the Bank of England.”


There is nothing mysterious about the failure of the Quantitative Easing (QE) or monetary loosening in stimulating real economy. The logic underlying QE is that additional cash will spur banks into lending more, consumers into spending more and, eventually, firms and companies into hiring more.


However, under the current fiat monetary set-up, it is the loan operation conducted by the banks i.e. banks giving loans to people, corporates and governments that creates the money supply. So, worthy borrowers and viable investment opportunities are critical in boosting the credit and thus money supply in the economy.


Interest rates are definitely one of the key components that determine the demand for credit and thus influence the money supply in the economy. However, demand for credit is also influenced by other factors such as demographics, investment opportunities and the existing level of debt in the economy.


The last, in fact, is the crux of the matter. American government, firms, companies and people are neck deep in debt. Low interest rates cannot boost credit growth until the existing levels of debt, which is the single biggest problem in the US economy, are allowed to liquidate. Any debt reduction, of course, runs counter to the objective of QE.


The first round of quantitative easing (QE1) had a measure of success because at that time during the peak of the financial crisis, the banks were cash strapped and the QE operation provided them with the much-needed liquidity. Today, liquidity is not a constraint for US banks. Giving them extra cash will change little so far as real economy is concerned.


Printing of currency, at the same time, diminishes the worth of paper money and strengthens the alternative to the dollar i.e. gold. It creates speculative price bubbles in oil, food and other commodities. We have seen how QE1 led to a 60 per cent increase in oil prices over a period and how QE2 saw crude oil prices go up by 35 per cent.


This suggests that the effects of QE3 on India will be double-edged. In the short term, QE will increase risk appetite in the world’s markets, and increase flows to emerging markets. That will support both the rupee and the Indian stock markets. However, given continued risks of policy implementation on the European side and with the ‘Fiscal Cliff’ in the US, sustained risk appetite is unlikely. In fact, stock markets have already reacted from the recent highs and so has the rupee.


On the flip side, there is no doubt that oil is headed upwards, taking many other commodities with it. High fuel prices will not only further stress the fiscal deficit, but the current account deficit as well. This is because QE3’s impact on the real economy globally, and thus on India’s export demand, might well be limited. The impact of the recent increase in diesel price would be washed out soon, making fiscal correction elusive. The prospect of increased liquidity worldwide and inflationary pressures of higher commodity prices will make it harder for the Reserve Bank of India to cut interest rates. Indian manufacturing’s recovery is likely to be delayed by higher input prices, as also high interest rates. The punters may celebrate the stock market’s gains; the government must watch out for the costs of the Fed’s money printing for India.


"The dollar is our currency but your problem," said the US treasury secretary John Bowden Connally, Jr. to a European delegation in 1971. Four decades later, it remains one.


The author is Executive Editor, Corporate India, and lives in Mumbai

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