Wednesday, 19 September 2012

The brave new world of QE Infinity….

“If the only tool you have is a hammer, every problem looks like a nail”! Abraham Maslow. 

That may well sum up the current predicament of Bernanke and many of his counterparts in Europe with interest rates at record low for about four years now.

After launching Quantitative Easing 1 (known as QE1) of US$1.65trillion and QE2 of US$600bn, to stave off deflation, Fed has now launched QE Infinity to boost employment. It has committed to buy $40bn of agency mortgage-backed securities every month until the labour market improves. An open ended commitment (as he has not been specific on unemployment targets) besides promising to hold the ultra-low rates until mid-2015.

It signals that he is prepared to hold an accommodative policy stance even if economy gains strength and has moved away from the deflation argument. But before we get to analyse the merits and effectiveness of QE Infinity, let’s understand the theory of behind benefits of QE and why some economists seem to worship it.

How does QE work?

QE is an unconventional emergency tool of monetary policy that the Central Banks can use to boost the economy by pumping liquidity into the system. The Central Bank generates fresh amounts of electronic money to encourage lending to businesses. Specifically, the Bank buys assets like Government and corporate bonds with its new cash. The companies selling those assets - usually commercial banks or other financial businesses such as insurance companies - will then have new money in their accounts, which in turn should feed into the wider economy. 

Central banks create money to buy government, and sometimes corporate, bonds, for three main reasons:
  • To reduce the cost of borrowing - buying government bonds increases their price and lowers their yield, which in turn puts downward pressure on interest rates across the spectrum;
  • To inflate asset prices - with bonds paying out lower interest rates, investors look to buy other asset classes, such as equities, real estate thereby pushing prices up;
  • To increase lending - by paying money to banks to buy bonds, the banks then have more money to lend to businesses and individuals.

In theory if QE works, credit growth should pick up and businesses should find it easier to get credit.

How is this different from actions of the 1920s Germany and Mugabe’s Zimbabwe?

Weimar Republic (German Reich) resorted to printing money to finance government debt and war reparation damages. The value of the Papiermark declined from 4.2 per U.S. dollar at the outbreak of World War I to 1 million per dollar by August 1923 and a further slid to 238 million to dollar by November 1923. Following this, new terms were negotiated, a new currency was introduced, at a rate of 1 trillion Papiermark for one Rentenmark, bringing back the US Dollar to 4.2 to a Rentenmark!

More recent actions of printing money were undertaken in Mugabe’s Zimbabwe. In 1980, Zim dollar was worth US$ 1.54. In March 2007, the Z$ 500,000-note was issued, signalling the official arrival of hyperinflation (more than 50% inflation per month). In January, 2009, Zimbabwe issued the one-hundred-trillion Zim dollar note, the largest denomination banknote ever!! It marked the end of the currency. In February 2009, the Reserve Bank of Zimbabwe introduced the fourth Zim dollar, which chopped off 12 zeros. Finally in 2009 the currency was abandoned, a humiliating end.

In contrast the US and the UK are buying asset backed securities and government bonds.  To the extent banks are required to hold government bonds as regulatory liquidity requirements, Central Banks buying of bonds indirectly feeds the government deficit financing, very similar to printing money!

Has it ever worked ?

No. Let's look at Japan’s lost decade(s) - After keeping rates near zero for an extended period, the Bank of Japan finally launched QE in March 2001 and dropped in March 2006. Over the five years, the Bank of Japan increased its outright purchases of longer-dated Japanese government securities driving the call-money rates to zero. The policy helped to stabilise the weak banks but failed to spur growth.

At first, it appeared the program had succeeded in stabilizing the economy and halting the slide in prices. But deflation returned with a vengeance, putting the Bank of Japan back on the spot. Critics say the Japanese central bank wasn't aggressive enough in launching and expanding its bond-buying program—then dropped it too soon. Others say Japan simply waited too long to resort to the policy.

BOJ officials have said quantitative easing wasn't the right tool to fight Japan's deflation, which was rooted in structural problems such as a rigid employment system that failed to eliminate redundant jobs to stay competitive.

Some economists support QE as the right medicine, then why doesn’t it work?

The arguments for QE are based on money multiplier effect. As the available reserves increases, banks ability to lend increases, creating the money multiplier effect leading to economic recovery.  But for this to work economic conditions needs to be different!

Factors that are NOT aiding monetary transmission or lending growth:
  1. Banks are over leveraged and capital deficient; additional cheap source of liquidity is helping it to refinance expensive funding and improve profitability; but very little flow through to the real economy;
  2. Interest rates have remained low for 4 years and yet demand has been muted, further QE is not going to spur demand;
  3. Over leveraged consumer, weak labour market combined with declining home prices have failed to create any new housing demand;
  4. Small business are not looking to borrow due to the uncertain economic outlook;
  5. Large corporations will borrow more at even lower rates — even though they’re already sitting on mountains of cash.
But such large corporation borrowing won’t create new jobs and may even lead to job losses as they invest their cheaper cash to achieve further economies through mergers and acquisitions. QE1 reduced corporate-borrowing rates by nearly a percentage point; while QE2 succeeded in bringing down corporate rates by only 13 basis points. The law of diminishing returns come into play.

Banks have increased their reserves with the Central Bank rather than use the proceeds of QE for further lending. The average level of excess reserves for banks was roughly $19 billion from 1984 to 2008.  
Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently!! As explained earlier, this is due to the combination of lack of demand for credit and overstretched balance sheet of banks.

While the pending inventory has dropped to pre-crisis levels of 6 months, this conceals the housing market weakness as the effects of foreclosure moratorium and pending foreclosures on home owners (estimated at 700,000) is not reflected in this. The average time take to foreclose has also increased from 4 months in to over 12 months. 

Once banks recommence their foreclosure process, the supply overhang will continue. This combined with lack of credit growth will push the housing market recovery further out. 

Quantitative easing didn’t help the Japanese economy, instead it only big Japanese companies and the current experience will be no different.

Do QE programmes have any effect on employment…

The chart shows net gains in employment since beginning of 2009 as compared to the number of individuals that have moved into the "Not In Labor Force" category where they are no longer counted. While there was an increase of 3.4 million jobs since the financial crisis, that is far lower for a sustainable economic recovery.  At the same time, more that 8.4 million have either "given up" or "retired" during that period. The decline in unemployment rate to 8.3% is partly as a result of a fall in workforce participation.
There is NO evidence that bond buying programs have any effect on fostering employment. However, at the current rate of individuals leaving the work force, Bernanke is likely to achieve low unemployment rate in the next few of years!  Of course, economic prosperity will have deteriorated much further as the rise of the "welfare state" persists.

The charts below show the number of individuals, since 2009, who are now claiming disability and food stamps and the increase in welfare costs.

If core inflation is benign, what is the harm in pursuing QE?

The Federal Reserve claims QE is not a problem because "core inflation" has been relatively contained. But core inflation excludes food and energy prices, which are two of the biggest components of consumer budgets and have been rising. On top of that, the average US household income has declined by over 9% since the onset of recession. As a result, food and energy consume more of wages and salaries it leaves less available for consumption within other areas of the economy. The chart below shows the consumer conundrum where declining wages meet up with rising costs of food and energy. With recent severe drought in the US food prices will only rise further. Of course, the USD benefits from its status as a reserve currency that offsets potentially severe outcomes.


The important point is that for businesses to hire require an increase in aggregate end demand. Rising inflationary pressures in food and energy prices only act as depressants to discretionary consumption thereby reducing the need for employers to expand capacity.  It is unlikely that the Fed's purchases of mortgage back securities will spur businesses to expand.  The inflation expectation has also risen above 2 per cent and there is little justification for additional QE at this point.


While QE will push liquidity into the equity markets thereby inducing higher asset prices - it will do little to help the economy, employment or housing.  Money will chase anything that is perceived as a “hard asset.” Industrial metals have already risen by 16.6 per cent since early August. The S&P is near all time highs, but if viewed in terms of gold it is 61 per cent below its 2007 high. Fed is engaged in debasing the dollar and this leading to competitive devaluation from other Central Banks (Japan has reacted). 

Monetary policy has a very limited reach economically and cannot be a substitute for fiscal policy measures that are required to promote economic growth.  

With the consumer sentiment weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand - there is little desire or need and even if there was, the banks are too constrained to lend.  This is unlikely to change anytime soon even as businesses are forced to pullback as demand is further reduced by rising inflationary pressures.

The lack of employment, lower incomes, excess debt and poor credit history will keep a large chunk of the population from qualifying to avail a mortgage for quite some time.  If the lowest mortgage rates in history could not lead a housing market recovery, there is little likelihood that a few more basis points will do the trick.

With QE Infinity, Bernanke is determined to pump up the US economy, full throttle. Be prepared for the next asset bubble burst, only this time it’s going to be a lot bigger and a lot more painful! 

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