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Can Quantitative Easing Work For The US?
August 27, 2010

The Federal Reserve initiated measures to pump US$1 trillion worth of liquidity into the economy on March 2009. The methods signify that the Fed is banking on the Quantitative Easing technique instead of expansionary fiscal or monetary policy. We evaluate the Quantitative Easing technique and try to examine its impact on the US economy.


Author : iFAST Research Team



Untitled Document
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Keynotes

  • Quantitative easing is an extreme type of monetary policy used to boost an economy where interest rates are essentially at, or close to zero, or expansionary monetary policies are no longer working.
  • Quantitative easing differs from expansionary monetary policy. The latter focuses on the price of money (interest rates) while the former focuses on the quantity of money.
  • QE does not necessarily cause hyperinflation or currency depreciation.
  • Excess liquidity prompted by quantitative easing may also be channeled into the asset markets. The speculative hot money in the financial and commodity markets would create asset price inflation.

On 18 March 2009, the Federal Reserve held its Fed Fund Target Rate at a range of 0% to 0.25% and stated that they will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The Federal Open Market Committee (FOMC) officially announced they would purchase US$300 billion of longer-term US Treasury securities over the next six months in order to improve the conditions in the private credit market. The Fed will also purchase up to US$750 billion of agency mortgage-backed securities (MBS) to support the mortgage and property markets. In addition, it will consider expanding the Term Asset-Backed Securities Loan Facility (TALF) to increase bank credit available for consumer and small-to-midsized enterprise loans. These initiatives, worth over US$1 trillion in total, signify that the Fed has commenced quantitative easing by pumping liquidity into the economy to prevent the credit crunch from deepening, as what was seen in the Great Depression.
Meanwhile, investors are concerned about the sustainability of this strong momentum and whether an economic slowdown is imminent, if not a double-dip recession.

What is Quantitative Easing?

Quantitative easing is an extreme type of monetary policy used to boost an economy where interest rates are essentially at, or close to zero, or expansionary monetary policies are no longer working. The aim of the policy is to increase the overall money supply through deposit multiplication by increasing lending and reducing the cost of borrowing to stimulate the economy. The central bank conducts open market operations by purchasing financial assets (consisting of government and corporate bonds, foreign currencies or gold) using money it has created ex nihilo (out of nothing), or simply put, money that has been printed by the central bank.

Quantitative easing differs from expansionary monetary policy. The latter focuses on the price of money (interest rates). It boosts the economy through the credit expansion. On the other hand, the former focuses on the quantity of money. It provides a higher liquidity (money supply) in the banking system to stimulate the economy.

Why use Quantitative Easing instead of Expansionary Monetary or Fiscal Policy?

Normally, central banks can stimulate the economy by lowering interest rates (expansionary monetary policy). It slashes interest rates by increasing the monetary base which includes the currency in circulation and banks’ reserves with the central bank. As the monetary base expands, the money in circulation through banks’ lending and deposit activities will also increase, thereby boosting the economy. This is explained by the Money Supply Model:

Money Supply = Monetary Base X Money Multiplier

The greater the money multiplier, the higher the money circulation, and the more effective the monetary policy would be. During the ongoing financial crisis, however, banks suffered a substantial loss of capital from the toxic assets. The rising non-performing loans have also curtailed the banks’ lending ability. They are less willing to lend due to the fears of counterparty risk, hence many companies are unable to get credit. As a result, the money multiplier has collapsed as shown in Chart 1. Despite interest rates being cut drastically from 5.25% in September 2007 to a historical low of 0.25% in December 2008, the M2 did not rise rapidly during the period. This means increasing the monetary base could not stimulate the economy as the money did not circulate. In other words, the expansionary monetary policy was not working.

In order to ease the credit squeeze, the Federal Reserve engaged in quantitative easing by purchasing MBS, agency bonds and US Treasuries. The action successfully lifted the money supply (M2) and reduced the cost of borrowing (30-year US Home Mortgage Rate) as depicted in Chart 2. It helped to improve the money market and financial market conditions. The Fed’s initiative also gave financial support to the companies that had financing pressures, preventing a large number of US corporate bankruptcies.

In terms of fiscal policy, the US has taken measures since the financial crisis started, with an aim to stabilise and revitalise the economy. In February 2009, Obama’s stimulus package worth US$787 billion was signed into law. In order to finance such huge spending, one way is to go into private capital markets to borrow the money. However, this could have two side effects:

1) Extensive fluctuation in financial asset markets as money will flow out from different asset markets into bond market

2) Increased cost of borrowing as the supply of government bonds soars.

As an alternative, the government can adopt quantitative easing to monetise its debts. In this case, the Treasury issues bonds on behalf of the government to the Federal Reserve. The Fed creates new money to pay for the bonds. That is, the Fed injects liquidity into Treasury by printing money in exchange for the government bonds. The government debts are hence monetised.

However, economic theory suggests that debt monetisation, or quantitative easing, can trigger some undesirable consequences like hyper-inflation and currency depreciation. We take a closer look at Japan’s experience to assess if that is the case.

Quantitative Easing and the Japanese Experience

Since the stock and property market bubble burst in the early 1990s, Japan’s government had paid little attention to the impacts of the resulting credit crunch. The Bank of Japan (BOJ) had even taken to tightening monetary policy, raising interest rates by 200 bps and maintaining the high interest rates for 18 months until mid-1991. The first recession-fighting stimulus package was only out two years after the bursting of asset bubble. Japan failed to ease deterioration in asset prices, the banking system, as well as the economy due to these mistakes on the policy front.

In March 2001, 11 years after the crisis, the BOJ finally adopted quantitative easing. In spite of the implementation, however, negative wealth effects resulting from the asset bubble burst (reduction in consumer wealth and expenditure, leading to falling employment and production) and the sluggish aggregate demand created a strong deflation pressure in Japan. Japan faced a protracted stretch of deflation as the Consumer Price Index (CPI) excluding food and energy was negative from 2001 to 2006. Still, the BOJ mistakenly judged that inflationary risks would be present in greater measure than deflationary risks in early 2006. To stabilise the price of goods, the bank took a strong anti-inflation stance, inducing Japanese households to expect that prices will continue to fall. This was a self-fulfilling deflationary expectation. In March 2006, 18 months before the core CPI would turn positive, BOJ decided to end quantitative easing and pursued a policy of monetary tightening. The policy change intensified deflation and seriously destroyed the balance between the credit supply and demand. Consequently, Japan’s quantitative easing could not bring back inflation, stimulate the credit activities or boost the economy.

Will Quantitative Easing Impact the USD Exchange Rate?

The Japanese case shows the policy did not bring hyperinflation as well as currency depreciation. Still, many investors, especially holders of US government bonds, fear that quantitative easing through extraordinary money printing by central banks could lead to US dollar depreciation. In fact, increasing money supply does not necessarily cause the dollar to collapse. Chart 3 illustrates that the US dollar rose against the Euro when the USD M2 growth was faster than the Euro M2 growth (December 1998 to December 2008).

We get the same result after examining USD exchange rates against other major currencies, including the Japanese Yen and Australian Dollar. We find that the USD appreciates when its supply increases. This paradox indicates increasing money supply doesn’t really result in currency depreciation.

This can be explained by the change in interest rate spread by other governments. Let’s take the example of the yen against the dollar.

The change in exchange rate between currencies is subject to the change in the interest rate spread between them. Let us use Japan’s case as an example. The yen dropped against all other major currencies except the US dollar during the period of quantitative easing. The reason is that the interest rate spread between JPY and USD narrowed at the time; the Fed slashed rates from 6.5% to 1% to revive the economy from the technology bubble burst. The narrowing interest rate spread made yen more attractive relative to the USD (see Chart 4).

The European Central Bank (ECB) and Bank of England (BOE) have also joined the Fed and the BOJ on the path of quantitative easing. Other major central banks worldwide are also embracing aggressive use of this monetary policy. The narrowing interest rate spread has maintained the dollar’s comparative advantage against these major currencies. Thus, the potential for large dollar depreciation due to the Fed “printing money” would be limited.

Inflationary Pressure

There is an argument that inflation will be back soon in the era of low interest and excess liquidity. However, we could also argue that global economy may not experience inflation in near future. Let’s recall the Quantitative Theory of Money: illustrates that the US dollar rose against the Euro when the USD M2 growth was faster than the Euro M2 growth (December 1998 to December 2008).

MV = PT

P is price level
V is the velocity of money
M is the total amount of money in circulation
T is the aggregate transactions

The money supply (M) increases as the Fed prints money and injects vast credit into the financial system. Since the aggregate transaction (T) plunges during the recession period, the level of prices (P) is likely to increase. However, credit crunch has reduced the velocity of money (V) as banks are not willing to lend and the loans growth is still far below from the normal level. As long as the velocity of money drops much faster than transaction, the increase in money supply may not result in inflation.

Apart from the circulation through banks’ lending, excess liquidity prompted by quantitative easing may also be channeled into the asset markets. The speculative hot money in the financial and commodity markets would create asset price inflation. For example, oil price has nearly doubled year-to-date in the first half of 2009, though the demand has declined. As inflation expectation has risen, a large amount of liquidity has entered into the oil futures market, triggering the pick-up in oil prices. This implies the financial needs rather than actual demands for commodities and assets have played a greater role in influencing the price. The large influx of liquidity in financial and commodities markets for speculation and inflation hedging can ultimately cause asset price inflation, which we experienced in the first half of 2008.

Conclusion

A sustained increase in liquidity through quantitative easing could foster economic recovery, provided the government responds and acts promptly. Lending directly to distressed parties through special facilities (TALF, TAF (Term Auction Facility), PDCF (The Primary Dealer Credit Facility), etc.) is also a necessary step to get credit flowing and to relieve the crisis. Combined with expansionary fiscal policy, the effect of quantitative easing would be intensified. Thus far, the US government has responded quickly and aggressively towards the financial crisis, sending a message that it will employ all available tools to prevent a worldwide economic catastrophe. It is expected that quantitative easing will provide a more desirable result in the US as compared with Japan.

The policy impact on exchange rate is subject to other central banks’ action on monetary policy. Currently, UK, Europe and Japan has already undertaken the quantitative easing while some other major central banks has also cut rates to record lows. Thus, the narrowing interest rate spread has maintained the US dollar’s comparative advantage. In terms of inflation, price level will rise only if global economies start to recover. A self-fulfilling inflation expectation, reflected by the speculation in various asset markets, could ultimately increase the overall price in economies.


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