The Quantitative Easing Binge
10/09/09 17:33
This is a good article by Karl Schamotta, Market
Analyst at Custom House where he answers
a question on Quantitative Easing.
The Quantitative Easing Binge
This week, one of our readers wrote in to ask about the long-term implications of quantitative easing programmes on currency and financial markets. This is a great question—the world economy has been on a monetary policy binge for the last year, and while we don’t have a lot of historical precedent to help us understand the consequences, the impact is likely to be large. Even in this day and age, numbers in the trillions are very substantial.
With fear and uncertainty dominating financial markets last year, investors and lenders around the world collectively put their money under their mattresses. Without any money circulating, there was a very real danger that the global economy would slow catastrophically. In response to these rapidly deteriorating conditions, governments started the printing presses and threw money into bailouts and infrastructure projects to support the underlying economy. In addition to these efforts in the real economy, central banks began putting money into the financial system, dropping interest rates to near zero and implementing the measures that have become known as quantitative easing.
The Quantitative Easing Binge
This week, one of our readers wrote in to ask about the long-term implications of quantitative easing programmes on currency and financial markets. This is a great question—the world economy has been on a monetary policy binge for the last year, and while we don’t have a lot of historical precedent to help us understand the consequences, the impact is likely to be large. Even in this day and age, numbers in the trillions are very substantial.
With fear and uncertainty dominating financial markets last year, investors and lenders around the world collectively put their money under their mattresses. Without any money circulating, there was a very real danger that the global economy would slow catastrophically. In response to these rapidly deteriorating conditions, governments started the printing presses and threw money into bailouts and infrastructure projects to support the underlying economy. In addition to these efforts in the real economy, central banks began putting money into the financial system, dropping interest rates to near zero and implementing the measures that have become known as quantitative easing.
Quantitative easing is a relatively simple procedure. The central bank purchases government- and mortgage-backed debt from the private sector by making an accounting entry crediting the reserve account of the selling institution. In essence, the central bank creates money out of thin air. This creates demand for debt instruments, which drives bond prices up and yields down, making lending more attractive and freeing up money for bank lending programmes.
The scale of this effort is difficult to exaggerate. Helicopter Ben began to throw money out of whirligigs. The U.S. Federal Reserve alone created over $1 trillion in new money, representing a doubling of total money supply over the last year. This is the largest percentage increase in history, managing to outdo the highest previous rise by a factor of ten. Banks worldwide also created new money at an unparalleled pace and are committed to adding much more over the next few years.
Due to the complexity of the financial system, the consequences of this avalanche of money are difficult to extrapolate. In the short term, these funds seem to have achieved their aim, finding their way into a number of asset classes, supporting prices, and giving the economy a substantial boost. Loose monetary policy in the United States has also had the effect of adding stimulus to the Chinese economy through the fixed exchange rate regime.
However, because the supply of goods and services remains largely fixed, the risk of rampant inflation in the longer run has become much higher. Alan Greenspan, the former Federal Reserve chief, recently said that he expects inflation between 3% and 10% in the coming years. Rising inflation necessarily leads to rising interest rates, which will have profound effects on equity returns and currency volatilities as traders react to changes in expectations.
The Federal Reserve is fully aware of these issues, but in order to forestall inflation, they must reabsorb this money supply by selling debt instruments and reducing bank reserves. Attempting to sell a trillion dollars in existing bonds at the same time that the government is issuing several trillion in new debt is likely to cause a spike in interest rates, curtailing economic growth and putting central banks into a quandary. It’s certainly possible to do this smoothly and effectively, but due to the delicacy of the operation, and its sheer scale, it seems quite unlikely.
In looking at the historical record, every previous monetary policy binge has resulted in inflation, and there is no reason to assume that this time will be any different. The hangover may be rough.