No, we are not talking about a British cruise ship. Our QE2 stands for a second round of quantitative easing, which is when central banks buy up government-issued debt, injecting money into the system to revive a sagging economy. The US Federal Reserve is considering another such buying spree to battle persistent deflationary pressures.
Another way to view QE is to see it as creating inflation. The minutes of the latest Fed meeting were explicit: Instead of avoiding deflation, the Fed now aims at provoking a healthy, in its view, round of inflation. While at first glance this might seem a minor shift in focus, a mere nuance, in fact it reflects a major policy bias.
Depending on the source of the numbers, QE2 could expand central bank money in the US by as much as two trillion dollars. If completely implemented, it would swell the US monetary base – all the money in public circulation or in commercial bank deposits held by the Fed – to five times its 2008 size, from USD 800bn to over USD 4trn (as in trillion).
QE1, as we might call the first wave of US quantitative easing, totaled roughly USD 1.5trn. It was aimed at stabilizing the banking system, which it did by purchasing the toxic assets from the balance sheets of financial intermediaries. This fresh money remained largely with the financial intermediaries and did not circulate in the broader economy. While it successfully stopped the liquidity crisis in the banking sector after the Lehman Brothers collapse, it did not reflate the economy. Indeed, credit remains the missing link in the struggling US recovery. Banks are still reluctant to lend, and overly indebted private households are still reluctant to borrow.
QE2 is likely to be a different sort of beast. Instead of healing the hemorrhages of financial intermediaries, the money will flow directly into the economy via the purchase of US government debt. As I noted in a previous editorial, this is nothing other than a monetization of debt, and it could, in my view, lead to a massive increase of inflation down the line.
With QE2, the Fed aims to accomplish several things. First and foremost, it wants to keep interest rates low at the long end of the yield curve, at least as long as investors’ inflation expectations remain subdued. Those low interest rates should be an incentive for households to borrow again, kick-starting the sluggish credit market.
That is the plan on paper, but it could well backfire. One thing is fairly likely: by flattening the yield curve, the Fed will make the lives of financial intermediaries more difficult. These institutions usually profit from steep yield curves, borrowing at the short end and lending at the long end. A flatter yield curve will slow the ongoing balance sheet repairs of financial intermediaries, which could make them even more reluctant to lend.
Not only that. By fanning expectations that interest rates could go even lower than they already are, the Fed could actually induce a wave of interest rate deflation. By this, I mean that households could postpone their borrowing in anticipation of even lower interest rates in the future. This is akin to deflation’s nasty effect, when purchases are delayed with the expectation that prices will decline yet further.
Another channel through which QE2 is supposed to support the US economy is the exchange rate. By buying US government debt with freshly printed money, the Fed is increasing the amount of US dollars in circulation. Hence, the price of the US dollar expressed in a foreign currency should fall, making US exports more competitive on international markets.
Here, again, the dots do not necessarily connect. If the Fed wants to use the printing presses to weaken the dollar, it needs to run them faster than the printing presses of all the other countries who are also trying to weaken their currencies (see: Japan, China or the UK). And should there be another euro crisis – which in my view is not unthinkable given the two-tiered recovery in Europe – the US dollar could strengthen again anyway.
Moreover, it is not certain that US exporters will really benefit even if the US dollar weakens. US growth has not been export-led for half a century. The notion that a weaker dollar would unleash a flood of US exports to China presumes that the US makes things that China actually wants to buy. We are not so sure.
In sum, QE2 offers a rather shaky prospect of a payoff for the real economy and an increased risk that inflation could dramatically surge. Defending quantitative easing, Fed Chairman Ben Bernanke recently said, “I do think that the additional purchases [of government bonds], although we don’t have precise numbers for how big the effects are … I do think they have the ability to ease financial conditions.” In my view, coming from the captain of this exercise, the person who should signal that he has everything under control, this hedged and foggy argument hardly inspires confidence.
Given the powerful tides and unpredictable currents it faces, this QE2 does not look very seaworthy at this point. Lifeboats, anyone?
No comments:
Post a Comment