Finance

Quantitative Easing What is it? What is its effect?

If it does this on a large enough scale, it can set off a chain of events, which in the past has been predictable, in terms of interest rates and inflation. The idea is to drive down the yield on long-term (10- to 30–year) US Treasury Bonds. Then the holders of long-term treasuries will sell off T-Bills, the low yield having made it an unattractive investment. The money from the sale of T-Bills then has to go somewhere, and there are only a few avenues down which to steer it. Do those avenues nourish and stimulate the economy? And what about the scariest side effect, inflation?

On November 3, 2010, the Federal Open Market Committee (FOMC), the policy-making organ of the Federal Reserve, announced a new round of bond purchases. Specifically, the FOMC said that the Fed will “purchase a further $600 billion of longer-term treasury securities by the end of the second quarter of 2011,” which represents “a pace of about $75 billion a month.” The Fed began pumping money into the U.S. economy in December 2008, in reaction to the failure of Lehman Brothers and the ensuing failure of confidence. That infusion of money has since been labeled Quantitative Easing One, or QE1, while the current round is called QE2.

After the government has purchased a bond, the bond seller can do anything that one can do with cash. Assume a lot of T-bills are sold to the Fed by Goldman Sachs. GS can use the money internally to improve the company operationally or through marketing; it can also use the money to make cosmetic changes like office renovations, or the money can be used to pay out executive bonuses or even to merge with or buy the assets of other companies.  But none of these options get the money out of the banking system itself in order to make its impact upon our overall economic health.

The real choice is from the following:
(1) banks can retain the cash or invest in corporate bonds, stocks or any other investment vehicles to thus raise their liquid reserves;
(2) they can give the money to their shareholders as dividends; or,
(3) they can lend the money out.

The stimulative effect requires that they do either option two or three above. A job creation effect also requires option three. The mechanism which motivates the selling of T-Bills, ironically, rests on the notion that, at first, the price of bonds will go up due to buying pressure. Presumably, in addition to the Fed’s buying spree, the higher price will make the effective yield of a fixed-interest payment on the bond go down, thus becoming unattractive to holders of bonds who will sell and, in so doing, shift their money out.

But the yield itself is going up. As of December 13, 2010, for example, the yield on a 10-year US Treasury Bond was 3.53 percent. Last August, around the time Bernanke started talking about the possibility of a QE2, the yield on 10-year bonds was between 2.5 and 3.0 percent. By the beginning of December, the rates  on 10-year bonds had begun moving up. In the first half of December, they’ve gone from 2.97 to 3.53 percent. Similarly, the yield on the 20-year bond has climbed from 3.95 to 4.37 percent. The yield on a 30-year bond has also risen from 4.24 to 4.59 percent.

The market prices of the bonds are not going up in response to increased buying demand, even though the Federal Reserve has directly purchased billions of dollars worth of bonds. Interest rates are not behaving as the Fed had anticipated. The most widely cited reason for the yield anomaly is that the market is pricing risk into US bonds that had once been thought to be risk-free. As Ron DeLegge, editor of ETF Guide, wrote recently, “The perception or belief that U.S. government debt is ‘risk-free’ is a wonderful myth perpetuated by academic textbooks which are in the process of being re-written” – a myth of security which may no longer be fooling foreign investors.

What has happened with the money that has been freed up by the purchases of T-Bills by the Fed? Thus far, lending activity has not increased.  According to the latest “beige book” (the official Federal Reserve statement on line: http://www.federalreserve.gov/fomc/beigebook/20101201/default.htm), “Banking conditions remained stable across most districts. Lending activity was reported as steady or unchanged in New York,Philadelphia, St. Louis, KansasCity, Dallas, and San Francisco, while a slight improvement was noted in Cleveland, Richmond and Chicago.”  

Nor are stockholders likely to receive a dividend windfall as a result of QE2. Indeed, the Fed has been actively discouraging such expectations (go to
http://www.federalreserve.gov/newsevents/speech/tarullo20101112a.htm).

So the banks, as the first-order recipients of this newly created money, are using that money to improve their balance sheets. In one sense, this is seen as a good thing. Banking institutions are investing in stocks, and to a lesser extent, in corporate bonds. While the restoration of stability to the money supply and the stock market is a singularly legitimate concern, by itself, it limits the degree and extent to which an increase in the money supply will have stimulative effects, as well, the limited degree to which it can address unemployment.

So far, there has been another perplexing development – the lack of an inflationary effect of quantitative easing to date. As Bernanke wrote in an op-ed piece in the Washington Post, “Low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating.”  He uses the phrase ‘gains in employment’ even though unemployment rates have not come down.

Dean Baker, co-director of the Washington-based Center for Economic and Policy Research, stated in an interview with The Suit Magazine (see adjoining article, “The Economic Forecast”), “If we’re lucky, we’re talking a couple of hundred thousand jobs, maybe lowering the unemployment rate by two percentage points. Certainly, that’s better than zero, but it’s just not going to have any really big effect.”

Justin Hoogendoorn, managing director for the Strategic Analytics Group for the Bank of Montreal, said, “It’s really more of a symbolic thing; they want to show that they’re doing something else to support the market, try and keep confidence in the US market high.”

Questions of inflation and devaluation are food for further thought, especially competitive devaluation. If anything, quantitative easing should result eventually in some inflation and, in confluence with low interest rates, devaluation. That makes our goods more affordable to the rest of the world, which is good for exports. But inflation can make it tough for middle to low-income families to afford basic expenses. Of course, inflation can spur people to open businesses now in anticipation of higher prices for goods in the future. With our current lack of inflation, the desire to stimulate inflation has been another dynamic and a reason to support quantitative easing.

The Japanese used quantitative easing at the end of their “Lost Decade,” an economic malaise which has been regarded as a classic case of deflation or a liquidity trap, but which bears little parallel to what is going on in the U.S. now. The state of this economy has given rise to a state of fear which Bernanke is addressing with quantitative easing, given that, right now, we have virtually zero inflation. Unlike the U.S. Federal Reserve, the Bank of Japan did not buy its country’s bonds. Instead, it lowered the “overnight call” rate that it had been charging commercial banks. The effect was the same, though – to flood the commercial banks with excess reserves which appears to have had a stimulative effect.

In 2006, economists working for the Federal Reserve Bank of San Francisco had authorized a study of the 2001 program of the Bank of Japan. “The program did produce some measurable declines in longer-term interest rates” in Japan, read the report, andchanges in the expectations of market participants about future interest rate levels. The findings also noted that, “there appears to be evidence that the program aided weaker Japanese banks and generally encouraged greater risk-tolerance in the Japanese financial system.” On the other hand, the report read, precisely because it propped up the weaker banks, the program “may have had the undesired impact of delaying structural reforms.”

So in the end, no one knows what the effect of quantitative easing will be.  QE2 has just begun, but quantitative easing has been going on since 2008. The Fed is already hinting at QE3. Two facts remain irrefutable: today’s lending activity hasn’t increased and unemployment hasn’t improved.
The major success of quantitative easing has been to maintain the stock market and reinforce the balance sheets of major financial institutions –  this is clearly short-term thinking, most probably delaying sorely needed structural reforms.


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