Repost: Quantitative Easing Pt. 5: QE3

Given the significance of last week’s announcement of QE3 from Fed Chairman Ben Bernanke, I decided to repost the blog’s discussion of QE3 from our series on quantitative easing last fall.  If you would like more information on historical uses of quantitative easing, or the past record of its implementation in the United States, I encourage you to look back at our five part discussion from November of 2011.  While the economy has certainly changed since our series was introduced, here are the predictions of the implementation of QE3 and its possible effects that we made:

The implications of QEIII:

Since the conclusion of QE2, speculation has begun to intensify surrounding the potential of a third round of quantitative easing, as Chairman Bernanke said that the central bank was prepared to ease further “if economic growth and inflation falter again.”[1]  In August, Goldman Sachs economists released a report predicting a third round of easing, and in a CNBC poll from the same month, 46 percent of economists surveyed stated they believe that QE3 will occur, versus only 37 percent disagreeing.[2][3]  Yet while the specifics of the plan remain ambiguous, critics of such a move suggest that the consequences of such an action will have a similar effect to that of QE2, with unemployment remaining high and GDP growth low.  Whereas deflation was a primary concern when considering QE2, it now appears that inflation is a realistic possibility, as the CPI has increased 3.6 percent over the past year, compared with a rate of 1.1 percent the year before.[4]  Further damaging the hypothetical effect of QE3 is political and economic turmoil both domestically and abroad.  The S&P downgrade of U.S. debt, as well as the debt crisis in Europe, has added greatly to an already elevated level of uncertainty within the global marketplace.  As uncertainty was a major factor in limiting the impact of QE2, firms and individual consumers seem to be more nervous than ever, making them less likely to spend or invest due to the difficulty of measuring the riskiness of their future cash flows.  “Monetary policy should help economic activity, but right now it’s just not working,” states Guy LeBas of Janny Montgomery Scott, “banks are taking that cash and just re-depositing it with the Fed.  It’s not that banks don’t want to loan money, it’s because they can’t.  There’s very little loan demand out there from consumers and businesses”.[5]

Another cause for concern when considering the ramifications of a third round of quantitative easing is the impact it may have on the United States image and faith in the dollar abroad.  When word of QE2 first broke, many countries around the globe were already in strong opposition given the programs devaluing effect on the dollar.  A devalued dollar does not only damage emerging economies, however, as many developed nations have called the Fed’s weak dollar policies currency manipulation which gives the country an unfair advantage in exports.[6]  Such international hostility can not only undermine economic recovery efforts, but also threaten long term prospects for the United States as a global economic leader.  It is not unfeasible to believe that should the U.S. continue to antagonize countries abroad by weakening the dollar, the world’s leading economies may ultimately drop the dollar as the world’s reserve currency.  According to a recent poll of central bank managers, a majority believes that the U.S. will lose this privilege within the next 25 years and be replaced by a basket of currencies.[7]  China has already taken action to negotiate deals without the use of dollars, “China supported a Russian proposal to start direct trading using the yuan and the ruble rather than pricing their trade or taking payment in U.S. dollars or other foreign currencies. China then negotiated a similar deal with Brazil.”[8]  Many of those who believe a shift in the reserve currency is coming point directly to the Federal Reserve’s expanded balance sheet and inflationary actions as exacerbating a trend away from the dollar as reserve currency, especially as growing economic powers such as China and Russia hold increasing amounts of U.S. debt.

The results of a shift from using the dollar as the world’s reserve currency in favor of a basket of currencies would be, by all indications, catastrophic for the United States economy.  The United States has been the world’s reserve currency since the Bretton Woods Conference in 1944, when the world’s leading economies established a system where international currencies tied their monetary policy to an exchange rate with the dollar.[9]  Since then, the dollar has maintained this status due to the ease and tools through which foreign countries could convert their currencies into dollars as, being as reserve currency, the dollar is held in large amounts by governments and other institutions around the world.  Another benefit of holding reserve currency status is that many commodity prices, such as oil and gold, are currently priced in terms of dollars, giving U.S. consumers the advantage of not incurring the cost and time of converting currencies to purchase such commodities.  If dollar reserve status was to shift, prices would inflate drastically in the U.S., hiking up energy costs for both firms and individuals.  General inflation within the economy stands to escalate as well given the drastic increase in dollar supply during the Fed’s first two rounds of quantitative easing.

Should such inflation occur, the Fed could hypothetically sell bonds on the open market to lower money supply, yet with the loss of reserve currency status, demand for U.S. bonds will drop drastically and the cost of financing debt will skyrocket.  In terms of competitiveness for American businesses, the effect of losing reserve status could be severely debilitating.  Since many international contracts are valued in dollars, American firms benefit from a competitive ease over international competition similar to the one held with commodities.  Should the dollar lose reserve status, these advantages would immediately disappear, and while a weaker dollar generally makes American exports more attractive due to their relative cheapness compared to foreign prices, firms would be operating on much thinner margins due to the increased cost of converting currencies and faced with the threat of increased federal taxes as the deficit grows.  Ultimately, the loss of reserve currency status for the greenback would severely undermine U.S. economic prospects by depressing consumption and investment levels, weakening U.S. competitiveness in the international market, and rendering monetary actions typically taken by the Federal Reserve to inject liquidity into the market less in an economic downturn less effective and much more expensive to finance, thus further increasing the federal deficit.

---

[1] See Waki.

[2] Handley, Meg. “Could QE3 Help the Economy?” Business News and Financial News. US News and World Report, 11 Aug. 2011. Web. 5 Nov. 2011.

[3] Washington, Jason Lange. “Federal Reserve Might Not Undertake QE3, And It Might Not Help If They Do.” Breaking News and Opinion on The Huffington Post. The Huffington Post, 13 Aug. 2011. Web. 9 Nov. 2011.

[4] See Handley.

[5] See Handley.

[6] See Washington.

[7] Furchy, Jack. “Dollar Seen Losing Global Reserve Status.” Financial Times. 27 June 2011. Web. 2 Nov. 2011.

[8] Hudson, Michael. “U.S. Quantitative Easing Is Fracturing the Global Economy.” The Market Oracle. 1 Nov. 2010. Web. 7 Nov. 2011.

[9] “The Rise of Bretton Woods | The Economist.” The Economist. 23 Oct. 2008. Web. 8 Nov. 2011.

 

Inflation Indicators Suggest QE3 Less Likely

A short article published in The Atlantic yesterday suggests that, based on past decision-making and Federal Reserve press releases, the likelihood that a third round of quantitative easing will occur is relatively low.  The graph below shows the relationship between the Fed’s balance sheet (blue) and core inflation (red).

Core inflation dropped significantly in 2009, and the Fed subsequently expanded its balance sheet with QE1 to combat the specter of deflation.  It again engaged in a quantitative easing program, QE2, in late 2010 when the core inflation continued to drop.  Now, however, inflation seems stabilized around the 2 percent level.  According to the Fed:

“A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.”

It appears that, unless inflation drops below this 2 percent level for a prolonged period, a third round quantitative easing is unlikely.

Stocks Respond Favorably as Bernanke Suggests Continued Fed Easing

 

 

 

 

 

 

 

Stocks rose above the 13,200 level in the Dow index today as investors responded positively to a speech made by Fed Chairman Ben Bernanke which suggested that continued lags in overall economic growth will likely require the Federal Reserve to continue its near-zero interest rate policy.  While Bernanke noted that significant improvements have been made in the unemployment rate recently, the rate remains high at 8.3% and the lack of overall economic growth makes it difficult to determine whether or not this improvement can be sustained.  Noting Okun’s law regarding economic growth and the unemployment rate, Bernanke admitted that given the modest economic growth, the recent improvement in unemployment statistics seems anomalous.  To reconcile this divergence from the Okun relationship, Bernanke suggested “that what we may be seeing now is the flip side of the fear-driven layoffs that occurred during the worst part of the recession, as firms have become sufficiently confident to move their work forces into closer alignment with the expected demand for their products.”

Chairman Bernanke remained noncommittal regarding the potential for another round of quantitative easing from the Fed.  His commitment to maintaining low-interest rates through 2014, however, contradicts sentiment within many corners of the economy which hypothesized that the recent improving economic metrics and unemployment data may lead to the Fed allowing an increase in the rate as early as 2013.

Quantitative Easing, Pt. 5: QE3

The implications of QEIII:

Since the conclusion of QE2, speculation has begun to intensify surrounding the potential of a third round of quantitative easing, as Chairman Bernanke said that the central bank was prepared to ease further “if economic growth and inflation falter again.”[1]  In August, Goldman Sachs economists released a report predicting a third round of easing, and in a CNBC poll from the same month, 46 percent of economists surveyed stated they believe that QE3 will occur, versus only 37 percent disagreeing.[2][3]  Yet while the specifics of the plan remain ambiguous, critics of such a move suggest that the consequences of such an action will have a similar effect to that of QE2, with unemployment remaining high and GDP growth low.  Whereas deflation was a primary concern when considering QE2, it now appears that inflation is a realistic possibility, as the CPI has increased 3.6 percent over the past year, compared with a rate of 1.1 percent the year before.[4]  Further damaging the hypothetical effect of QE3 is political and economic turmoil both domestically and abroad.  The S&P downgrade of U.S. debt, as well as the debt crisis in Europe, has added greatly to an already elevated level of uncertainty within the global marketplace.  As uncertainty was a major factor in limiting the impact of QE2, firms and individual consumers seem to be more nervous than ever, making them less likely to spend or invest due to the difficulty of measuring the riskiness of their future cash flows.  “Monetary policy should help economic activity, but right now it’s just not working,” states Guy LeBas of Janny Montgomery Scott, “banks are taking that cash and just re-depositing it with the Fed.  It’s not that banks don’t want to loan money, it’s because they can’t.  There’s very little loan demand out there from consumers and businesses”.[5]

Another cause for concern when considering the ramifications of a third round of quantitative easing is the impact it may have on the United States image and faith in the dollar abroad.  When word of QE2 first broke, many countries around the globe were already in strong opposition given the programs devaluing effect on the dollar.  A devalued dollar does not only damage emerging economies, however, as many developed nations have called the Fed’s weak dollar policies currency manipulation which gives the country an unfair advantage in exports.[6]  Such international hostility can not only undermine economic recovery efforts, but also threaten long term prospects for the United States as a global economic leader.  It is not unfeasible to believe that should the U.S. continue to antagonize countries abroad by weakening the dollar, the world’s leading economies may ultimately drop the dollar as the world’s reserve currency.  According to a recent poll of central bank managers, a majority believes that the U.S. will lose this privilege within the next 25 years and be replaced by a basket of currencies.[7]  China has already taken action to negotiate deals without the use of dollars, “China supported a Russian proposal to start direct trading using the yuan and the ruble rather than pricing their trade or taking payment in U.S. dollars or other foreign currencies. China then negotiated a similar deal with Brazil.”[8]  Many of those who believe a shift in the reserve currency is coming point directly to the Federal Reserve’s expanded balance sheet and inflationary actions as exacerbating a trend away from the dollar as reserve currency, especially as growing economic powers such as China and Russia hold increasing amounts of U.S. debt.

The results of a shift from using the dollar as the world’s reserve currency in favor of a basket of currencies would be, by all indications, catastrophic for the United States economy.  The United States has been the world’s reserve currency since the Bretton Woods Conference in 1944, when the world’s leading economies established a system where international currencies tied their monetary policy to an exchange rate with the dollar.[9]  Since then, the dollar has maintained this status due to the ease and tools through which foreign countries could convert their currencies into dollars as, being as reserve currency, the dollar is held in large amounts by governments and other institutions around the world.  Another benefit of holding reserve currency status is that many commodity prices, such as oil and gold, are currently priced in terms of dollars, giving U.S. consumers the advantage of not incurring the cost and time of converting currencies to purchase such commodities.  If dollar reserve status was to shift, prices would inflate drastically in the U.S., hiking up energy costs for both firms and individuals.  General inflation within the economy stands to escalate as well given the drastic increase in dollar supply during the Fed’s first two rounds of quantitative easing.

Should such inflation occur, the Fed could hypothetically sell bonds on the open market to lower money supply, yet with the loss of reserve currency status, demand for U.S. bonds will drop drastically and the cost of financing debt will skyrocket.  In terms of competitiveness for American businesses, the effect of losing reserve status could be severely debilitating.  Since many international contracts are valued in dollars, American firms benefit from a competitive ease over international competition similar to the one held with commodities.  Should the dollar lose reserve status, these advantages would immediately disappear, and while a weaker dollar generally makes American exports more attractive due to their relative cheapness compared to foreign prices, firms would be operating on much thinner margins due to the increased cost of converting currencies and faced with the threat of increased federal taxes as the deficit grows.  Ultimately, the loss of reserve currency status for the greenback would severely undermine U.S. economic prospects by depressing consumption and investment levels, weakening U.S. competitiveness in the international market, and rendering monetary actions typically taken by the Federal Reserve to inject liquidity into the market less in an economic downturn less effective and much more expensive to finance, thus further increasing the federal deficit.

---

[1] See Waki.

[2] Handley, Meg. “Could QE3 Help the Economy?” Business News and Financial News. US News and World Report, 11 Aug. 2011. Web. 5 Nov. 2011.

[3] Washington, Jason Lange. “Federal Reserve Might Not Undertake QE3, And It Might Not Help If They Do.” Breaking News and Opinion on The Huffington Post. The Huffington Post, 13 Aug. 2011. Web. 9 Nov. 2011.

[4] See Handley.

[5] See Handley.

[6] See Washington.

[7] Furchy, Jack. “Dollar Seen Losing Global Reserve Status.” Financial Times. 27 June 2011. Web. 2 Nov. 2011.

[8] Hudson, Michael. “U.S. Quantitative Easing Is Fracturing the Global Economy.” The Market Oracle. 1 Nov. 2010. Web. 7 Nov. 2011.

[9] “The Rise of Bretton Woods | The Economist.” The Economist. 23 Oct. 2008. Web. 8 Nov. 2011.

Quantitative Easing, Pt. 4: QE in the United States

Current use of Q.E. in U.S. and the decision to implement QEII:

Whereas the decision of the Bank of Japan to implement their quantitative easing policy was more a result of fundamental problems which had afflicted the Japanese economy for an extended period of time, the decision by the United States Federal Reserve to undertake similar policy actions was motivated by rapid global economic decline.  For the United States, the implementation of the Federal Reserve’s quantitative easing programs occurred during two distinctive periods, known as “QE1” and “QE2”.  The first round of quantitative easing, QE1, lasted from December 2008 until March 2010, and employed a three point attack on the stagnant economy which focused on increasing liquidity both inside and outside of the banking sector, as well as easing economy wide credit by lowering a wide range of interest rates.

To fulfill their first objective, the Fed established the Term Auction Facility, or TAF, in an effort to expand access to money in their lender of last resort role.  TAF worked by using an anonymous auction system to lend funds to banks, domestic only at first, and then to international banks as well later on.[1]  To increase liquidity outside the banking sector, the Fed was authorized to purchase up to $200 billion of asset-backed securities.  Finally, to impact the yield on longer-term assets, the Fed bought $600 billion of debt and mortgage-backed paper held by federal agencies as well as long-term Treasuries.  By the end of the program, the Fed purchased $1.7 trillion of Treasury and mortgage-backed securities.  Economists at the Federal Reserve Bank of New York estimate that these Treasury purchases resulted in a drop of half a percentage point on longer-term Treasury yields.[2]  Yet despite the progress made on Treasury yields, mortgages and loans remained difficult to qualify for and expensive to obtain, and the benchmarks of the Fed’s dual mandate targeting unemployment and inflation both lagged, with unemployment around 9.6% for the period and the inflation rate lower than the generally accepted target between 1.7% and 2%.[3]

While the first round of quantitative easing worked toward accomplishing a number of goals set by the Fed, such as the lowering of longer-term yields, in the face of heightened unemployment levels, as well as the fear of persistent deflation, the Federal Reserve announced in November 2010 a second round of easing, or “QE2.”  In contrast to the more expansive and diverse actions taken by the Fed during QE1, the QE2 program focused solely on the purchase of longer-termed government securities, much like the Bank of England’s program.  Over an eight month period ending in June 2011, the Federal Reserve committed to purchasing $75 billion of Treasury securities, primarily ones with maturities of two to ten years, averaging to around five or six years.[4]  By June of 2011, the Fed had bought $600 billion worth of Treasuries in an effort continue the downward pressure on longer-termed yields.  After the initial announcement of QE2, riskier and higher-yielding assets experienced an upward jolt as the lower yields on longer-term securities pushed investors into riskier assets with the promise of higher returns.  Yet while this initial surge in prices seemed to signify the success of QE2, the true impact on the U.S. economy remains questionable, especially regarding employment levels.

As commodity, specifically energy, prices shot up, consumers spent less on non-energy expenditures and firms, which would hypothetically be more willing to undertake long-term investment projects due to the ease in credit, were faced with higher production costs.  The result has been a significant slowdown within the economy as the previously spiked asset prices have retreated.[5]  Stephen Jen, partner at the SLJ Partners hedge fund, reasoned that there would “be a few weeks of positive reaction, followed by a sell-off, as investors realize the circular and pointless logic of the argument that QE2 could lead to permanent increases in economic activities”.[6]  Daniel Thornton, Vice President of the Federal Reserve Bank of St. Louis, predicted the fact “that analysis suggested several reasons why QE2 might have little or no effect on output, or employment,” as well as cautioning that further Treasury purchases could cause “unprofitable lending due to interest rates at or below the cost of capital, thereby encouraging banks to hold excess reserves rather than make loans”.[7]

While in the short term it appeared that the program of Treasury purchases proscribed by QE2 would have a positive impact on the economy, it now appears that the gains in asset prices were artificially inflated, and eventually undermined by high commodity prices.  Additionally, given the role the dollar has in emerging economies where currencies are largely pegged to the dollar or held to a tight exchange rate, QE2 not only risked inflating commodity prices, but prices in emerging economies as well.[8]  Though a primary cause of concern within the United States, deflation, seems to no longer to be a major possibility, the inflationary pressures caused by this second round of quantitative easing on both commodity prices and within the emerging economies, as well as the continued stagnancy of the economy, suggests that the program cannot be qualified as successful.  Even the effect the program had on flattening the yield curve has done little to improve overall investment levels and lending and borrowing remains tight within the economy.  This lack of response amongst lenders and borrowers seems to signify that given the general uncertainty experienced by businesses, both from future growth prospects as well as regulatory increases, lowering the cost of long-term debt financing alone will not stimulate economic investment.  In this way, Federal Reserve action can have a positive impact on the economic recovery, yet the complexity of the economic and political issues within the country can greatly mitigate the impact of policy actions.  By realizing these limitations and potential obstacles in policy effectiveness, along with the negative effects on consumption due to the inflated prices of commodities, it becomes apparent that despite the fact that this round of quantitative easing properly targeted the fundamental issues of the economy, the real results of the policy illustrates that it was not a good decision.

---

[1] See Klyuev et al.

[2] See Reddy.

[3] See Reddy

[4] See Reddy.

[5] Waki, Natsuko. “Analysis: QE3 May Do More Harm than Good| Reuters.” Business & Financial News. Reuters, 27 July 2011. Web. 8 Nov. 2011.

[6] See Waki.

[7] Thornton, Daniel L. “The Downside of Quantitative Easing.” Economic Synopses. Federal Reserve Bank of St. Louis, 10 Nov. 2010. Web. 30 Oct. 2011.

[8] See Waki.

Quantitative Easing, Pt. 3: A History of Quantitative Easing

History of Q.E. and previous uses:

Much of the negative connotation of the term inflation and apprehension surrounding the concept comes from the hyperinflation experienced by Germany, which began after WWI in 1921 and lasted until 1924.  The origins of this inflationary problem began for the Germans when the country’s leaders, convinced that the First World War would be short-lived, chose to finance their military operations through monetary expansion rather than increased savings and taxation.[1]  To do this, German leaders suspended citizen’s ability to convert their German marks into gold and this, combined with the increased monetary production to finance the war, led to a 50% drop in the mark’s value against the dollar by the end of 1918.[2]

In 1919, the Treaty of Versailles destroyed Germany’s high aspirations in two ways: first by marking the official surrender and disarmament of the German army, and second, by demanding reparations of $12.5 billion, an especially excessive amount for the time.[3]  In his book The Economics Consequences of the Peace, John Maynard Keynes prophesized the economic and political disarray which would plague the German Republic following the treaty, and in regards to the relationship between monetary creation and inflation found that “the inflationism of the currency systems of Europe has proceeded to extraordinary lengths”.[4]  Keynes’ prediction soon proved correct, as by 1924, German marks in circulation reached 497 quintillion, exponentially larger than their level of 29.2 billion just five years before.  To make matters worse, when the Germans defaulted on reparations payments, the French and Belgians occupied the German region of Ruhr, their “industrial heartland,” which produced 85 percent of the country’s coal.[5]  In the same year, the exchange rate was 1 trillion marks per dollar and a wheelbarrow of marks was insufficient to buy a newspaper.  Workers began to be paid twice daily, at which point they would rush to local businesses to buy supplies before the price hiked any further.[6]  As the Economist notes, by the time hyperinflation had stabilized in 1924, the effect had been so severe that many in Germany were ready to believe that “Germany had been stabbed in the back by a conspiracy of Jews, international financiers and local appeasers”.[7]  Though not the sole factor, the oppressive terms of the Treaty of Versailles and the subsequent German hyperinflation, was a major contributing factor in the rise of Adolf Hitler’s National Socialist Party and the tension which caused WWII.

Hyperinflation within global economies is a problem which is still of relevant concern today, a fact illustrated by the hyperinflation experienced by Zimbabwe.  The primary causes of Zimbabwe’s hyperinflation was a drop in their overall economic output, as domestic productive capabilities were greatly debilitated by turmoil following the country’s civil war and confiscation of white-owned land.[8]  The problem was exacerbated by President Robert Mugabe’s decision to abandon the keeping of financial statistics on inflation within the country.  As production continued to fall, and the government printed more money to attempt and solve the problem, inflation rates soared, reaching 231 million percent by October 9^th, 2008.  To combat the problem, the Zimbabwean government abandoned its currency in 2009, and because the country has yet to release a new currency, prices in the country are currently set in U.S. dollars.[9]

Despite historical evidence, noted by the Wall Street Journal’s Jason Zweig, that the United States adopted an approach similar to the modern asset-buying program to deal with the recession of 1866 by buying bonds and flooding the markets with cash, overall consensus on the origins of the modern conception of “quantitative easing” and Fed action points to the policy decisions of the Bank of Japan from 2001-06.[10]  In 1999, the Japanese economy was hampered by deflation, and after lowering short-term interest rates to close to zero in 1999 in a policy dubbed ZIRP (Zero Interest Rate Policy), the Bank of Japan was still unable to reinvigorate their struggling economy and a liquidity trap ensued.[11]  To further stimulate the economy, on March 19^th, 2001, the Bank of Japan adopted a QEP (quantitative easing policy) in an attempt to maintain their ZIRP “until the core CPI registers stably a zero percent or an increases year on year”.[12]  To accomplish this goal, the Bank shifted its primary focus from the overnight call rate to the current account balances within their banks, and the Bank of Japan “increased its target for ‘current account balances’ at commercial banks far in excess of required reserve levels, over-capitalizing the banks thus forcing them to lend more at minimal risk”.[13]  Additionally, Japan’s central bank instituted a program of Japanese Government Bond, or JGB, purchases to stimulate long term investment, raising the ceiling on long-term JGB purchases “from 400 billion yen to 1.2 trillion”.[14]  The reasoning was that by purchasing these longer-termed bonds, the yield curve on JGBs would flatten, making short and long term debt closer to perfect substitutes, thus incentivizing firms to invest in longer term investment and more readily inspire the Japanese economy to not only shake the malaise that was pervasive in the current economic conditions through immediate consumption but also to be sufficiently capitalized and equipped to grow at a healthy rate in the future.

Some have argued that the quantitative easing program of the Bank of Japan also “specifically targeted weaker areas of the Japanese financial system to maintain the pace of credit creation”.[15]  Policy Board minutes from the period seem to give legitimacy to these assertions, showing that “some members were particularly moved to embark on the quantitative easing policy as a vehicle to maintain the rate of credit creation by Japanese commercial banks”.[16]  This action seemed imperative at the time due to the credit downgrades experience by “19 Japanese banks,” as the Bank of Japan realized that without sufficient credit in the economy, their actions to both improve overall liquidity and incentivize long term investment would prove moot.  Overall, the quantitative easing program adopted by the Bank of Japan was one designed at battling deflation within the economy, a goal which they worked to accomplish by not only directly injecting liquidity within the market, but also by targeting long term interest rates and the credit of commercial Japanese banks.  Important to understanding the modern connotation of the term “quantitative easing,” and Ben Bernanke’s subsequent desire to distance the actions of the Federal Reserve from the classification of being directly modeled after Japan’s policies, was the success of the Japanese program itself.

In 2006, the Federal Reserve Bank of San Francisco released an economic letter by Vice President Mark Spiegel assessing the overall success of Japan’s quantitative easing program as it winded down.  As is typical of any economic policy decision, the FRBSF letter addresses the conflicting empirical results of the program in their current account balance and longer term interest rate targeting.  Spiegel ultimately concluded that, given the mixed assessments of the program’s impact on current account balances, as well as its effects on long-term bond yields, the Bank of Japan’s quantitative easing experiment failed in a number of key benchmarks.  While there appeared “to be measurable declines in longer-term interest rates,” as well as a “greater risk-tolerance in the Japanese financial system,” the program failed in two regards: first, it failed to completely quell the deflation which plagued the economy at the time and second, that by “strengthening the performance of the weakest Japanese banks” the program may have inadvertently had “the undesired impact of delaying structural reform”.[17]

Though Spiegel’s assessment of Japan’s quantitative easing as damaging to financial reform within the country may qualify as a subjective opinion, the claim regarding Japanese deflation during the time is supported by tangible evidence.  From the years 2005-10, Japanese inflation rate fluctuated in a range of between -2.5 percent and 2.3 percent with a mean of -0.09 percent.[18]  In his critique of the system, Bank of Japan Governor Masaaki Shirakawa quantifies this statistic as evidence that the program did not effectively “change the perception in financial markets that deflation would persist”.[19]  An IMF report on quantitative easing finds that “most believe that the failure to deal resolutely with the undercapitalized banking system had doomed the monetary and fiscal efforts to reignite the economy”.[20]  Based on the fact that deflation within the Japanese marketplace was the primary cause of the country’s economic problems, the pervading consensus that the actions of the Bank of Japan were not able to address this fundamental problem does not lend itself to viewing the policies as successful as a whole.  Given the, what Shirakawa calls “striking similarities” found by many between the Bank of Japan’s policy actions and those adopted by the Federal Reserve in the years since the 2007 downturn, it is not difficult to see why Chairman Bernanke would hope to distance the classification of the Federal Reserve’s policies from those of the Bank of Japan.

The Federal Reserve is not alone in their implementation of QE programs in response to the 2007 financial collapse, however, as other leading economies have implemented similar quantitative easing policies, the Bank of England being one of these countries, beginning their own QE policy in March of 2009.  Explaining their policy decisions, the Bank of England states that when interest rates “are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money,” through a process that “is sometimes known as ‘quantitative easing’”.[21]  Their approach to this monetary creation is different in composition than the Fed’s actions; as despite the Bank’s claims that it “creates money and uses it to buy assets such as government bonds and high-quality debt from private companies,” the majority of their balance sheet expansion is from the purchase of government bonds.[22]

While the Bank of England’s “Credit Easing Program” has authorized the purchase of up to 50 billion pounds of a “a broad range of high-quality private assets, including commercial paper and corporate bonds, as of November 2009, such purchases amounted to only 1 billion pounds, versus 75 billion pounds spent on a three month “Asset Purchase Program” focused mainly on the purchase of medium to long-term government notes and bonds.[23]  The Bank of England has placed an explicit goal of achieving a target rate of 2 percent for inflation, a goal it hopes to achieve by both increasing the available cash for private companies through corporate asset purchases, as well as by injecting more money into bank reserves to increase economy wide lending.

Despite their explicit inflationary goal, however, empirical evidence shows that bank lending within the private, non-financial sector has turned negative in the U.K., and though corporate bond spreads have narrowed, the small amount of their balance sheet which is occupied by the corporate bond purchases seems to be the primary issue.  Both the balance sheets of the United States and the United Kingdom have grown substantially since they have adopted their respective programs, yet the composition of the U.K.’s balance sheet is much more heavily focused on the purchases of government bonds in contrast to the more diverse holdings of the Fed balance sheet.[24]

---

[1] Goodman, George. “Commanding Heights : The German Hyperinflation, 1923.” PBS. Public Broadcasting Service, 1981. Web. 8 Nov. 2011.

[2] Edition, Print. “Millennium Issue: German Hyperinflation: Loads of Money | The Economist.” The Economist. 23 Dec. 1999. Web. 4 Nov. 2011.

[3] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.

[4] Keynes, John Maynard. “Commanding Heights : Keynes on Inflation.” Economic Consequences of the Peace. PBS, Aug. 1919. Web. 13 Nov. 2011.

[5] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.

[6] See Goodman.

[7] See . “Millennium Issue: German Hyperinflation: Loads of Money | The Economist”.

[8] Coltart, David. “A Decade of Suffering In Zimbabwe.” The Cato Institute. The Cato Institute, 24 Mar. 2008. Web. 6 Nov. 2011.

[9] “Zimbabwe Abandons Its Currency.” BBC News. British Broadcasting Company, 29 Jan. 2009. Web. 7 Nov. 2011.

[10] Zweig, Jason. “Quantitative Easing New? Don’t Believe It – Total Return – WSJ.” WSJ Blogs – WSJ. The Wall Street Journal, 31 Oct. 2011. Web. 9 Nov. 2011.

[11] See Klyuev et al.

[12] See Klyuev et al.

[13] Allen, Glen. “Quantitative Easing – A Lesson Learned from Japan | Oye! Times.” Oye! Times. 3 Nov. 2010. Web. 4 Nov. 2011.

[14] Spiegel, Mark M. “Did Quantitative Easing by the Bank of Japan “Work”?” The Federal Reserve Bank of San Francisco: Economic Research, Educational Resources, Community Development, Consumerand Banking Information. 20 Oct. 2006. Web. 1 Nov. 2011.

[15] See Spiegel.

[16] See Spiegel.

[17] See Spiegel.

[18] See Allen.

[19] See Shirakawa.

[20] See Klyuev et al.

[21] Bank of England. Quantitative Easing Explained. London: Bank of England, 2009. Public Information and Enquiries Group. Bank of England, Oct. 2009. Web. 4 Nov. 2011.

[22] See Klyuev et al.

[23] See Klyuev et al.

[24] See Klyuev et al.

Quantitative Easing, Pt. 2: A Brief Explanation of the Concept

What is Q.E. and why is it used?           

Though there are “no generally accepted definitions” for the nomenclature used to describe the Federal Reserve’s actions, be it “quantitative easing” or Bernanke’s preferred title of “credit easing,” the specific actions of QE1 and QE2 seem to indicate that the Fed’s programs of monetary expansion and asset-purchasing most closely resembles Japan’s definition of quantitative easing.  Quantitative easing in the contemporary sense “works through inflating asset prices, lowering prices, lowering the exchange rate and raising inflation expectations, and thus reducing real interest rates”.[1]  Historically, during such a time of economic uncertainty central banks would institute expansionary monetary policies, carried out through open market operations, to lower the yield on short-term interest rates and inject more money into the economy.  Commercial banks will often use the central bank as a source of additional liquidity when offering loans and the lower the short-term interest rate, the less it costs them to access these supplementary funds.  Yet this expansionary policy has a limit, as when these short-term interest rates fall to levels of near zero, a “liquidity trap” ensues, and these expansionary monetary policies are rendered largely ineffective.[2]

When this becomes the case, central banks are forced to adopt more “unconventional” monetary policies to further stimulate economic conditions.[3]  To do accomplish this, central banks can implement quantitative easing programs which attempt to reinvigorate economic conditions by expanding their balance sheet through the purchase of both public and private assets to further expand the money supply and lower long-term interest rates. These purchases will, in turn, inject liquidity into the economy by increasing the demand for these private and public assets, providing excess cash for private firms and lowering the yield offered on government debt.  By increasing the cash reserves of private firms and lowering the yield on long-term government debt, the central bank can hypothetically arouse an increase in both immediate consumption levels and spur a rise in investment by easing credit and lowering the cost of lending and borrowing amongst both firms and consumers.

Given quantitative easing’s use of electronic monetary creation and deficit spending, much of the criticism aimed at quantitative easing is based on the argument that with such a policy, “the planned asset purchases risk currency debasement and inflation”.[4]  Though some inflation is good for an economy, and quantitative easing can be a viable response to deflation within an economy, the scope of most quantitative easing policies risks severely devaluing the currency and putting excessive inflationary pressures on the economy.  Additionally, since much of the asset purchases of a quantitative easing program are composed of government debt, critics are wary of the effect such programs will have on the long-term prospects of a country based on the sizable increase in deficit spending quantitative easing programs employ.

---

[1] Reddy, Sudeep. “Quantitative Easing: How It Works; When It Doesn’t.” Business News & Financial News. The Wall Street Journal, 4 Nov. 2010. Web. 5 Nov. 2011.

[2] Eggertsson, Gauti B. “”Liquidity Trap”" New York Federal Reserve. Web. 4 Nov. 2011.

[3] See Klyuev et al.

[4] Asness, Cliff, Michael Boskin, and Richard Bove. “Open Letter to Ben Bernanke.” Letter to Ben Bernanke. 15 Nov. 2010. Wall Street Journal. Web. 11 Nov. 2011.

Quantitative Easing in the United States: An Examination of its Historical, Contemporary and Future Uses Pt. I

Over the next few days, we will be posting a multiple part series examining quantitative easing in the United States, beginning with its historical beginnings all the way through the possibility and implications surrounding QE3.  The series begins below with an introduction of the topic:

Introduction:

In the early fall of 2007, the American economy was thriving, with housing prices, company profits and stock market indexes reaching historically high levels.  Though the dot com bubble crash of the early 2000’s had occurred less than a decade before, the booming economy had now pushed the Dow Jones Industrial Average to nearly twice its level at the bottom of the 2002 crash, peaking at nearly 14,200 on October 11, 2007.[1]  This elevated level of economic prosperity was short-lived, however, as the housing bubble which had fueled the economic rise soon crashed as subprime mortgages default rates began to soar.  The stock market began to fall, crashing a year later in October of 2008 and falling to just over 6,600 by March of 2009.[2]  The collapse of 2007 has left the global economy in a continued state of both economic depression and uncertainty.  The underlying causes of this meltdown are a combination of failures of both complex financial instruments and regulatory bodies, as well as a misrepresentation of overall institutional risk and overextended credit.  In their Levin-Coburn Report, the United States Senate concluded that “the crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street”.[3]  The subsequent collapse of Lehman Brothers, a financial services firm which at the time of its bankruptcy held $613 billion worth of debt, further exacerbated the problem and sent shockwaves through the already fragile global economy.[4]  In response, governments across the world adopted a variety of fiscal and monetary policies to try and limit the damage and reinvigorate the international marketplace.  In the United States, Congress implemented fiscal policies such as the American Recovery and Reinvestment Act of 2009 to lower unemployment that plagued the economy through a series of “shovel ready” projects, similar to those of the New Deal during the Great Depression.[5]  Simultaneously, the Federal Reserve began a series of unconventional monetary policies to try and inject liquidity into the marketplace.  These policies, inspired largely by the Bank of Japan’s actions in the early 2000’s, were a series of “quantitative easing” measures designed to jumpstart economic lending and investment.

To date, the Fed has implemented two major quantitative easing programs, commonly referred to as “QE1” and QE2,” as vehicles for this recovery.  While these programs have “contributed to the reduction in systemic tail risks following the bankruptcy of Lehman Brothers,” the overall success of their implementation remains ambiguous as “financial conditions remain tight” and bank lending channels remain “strained”.[6]  As the economic recovery remains slow and dragging, speeches by leading Fed officials seem to indicate another round of quantitative easing, or “QE3,” may be on the way.  Amongst leading economists, the relative success of such a program remains uncertain and contentious, with critics pointing that the country may be “reaching a point of ‘diminishing returns’ with its asset-purchasing programs”.[7]  Given the lack of definitive empirical evidence to support either side’s claims, as well as the exceedingly polarized political environment within the county, it appears that a program such as QE3 will do little more than increase the uncertainty within the markets that continues to hamper lending and investment level, making such a program ultimately ill-advised.

---

[1] “Google Finance: Dow Jones Industrial Average.” Google. Web. 9 Nov. 2011.

[2] See DJIA.

[3] Levin, Carl, and Tom Coburn. “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse.” United States Senate. 13 Apr. 2011. Web. 3 Nov. 2011.

[4] Mamudi, Sam. “Lehman Folds with Record $613 Billion Debt – MarketWatch.” MarketWatch. 15 Sept. 2008. Web. 6 Nov. 2011.

[5] Press Release. “The Recovery Act.” Recovery.gov – Tracking the Money. 17 Feb. 2009. Web. 9 Nov. 2011.

[6] Klyuev, Vladimir, Phil De Imus, and Krishna Srinivasan. “Unconventional Choices for Unconventional Times: Credit and Quantitative Easing in Advanced Economies.” IMF. International Monetary Fund, 4 Nov. 2009. Web. 7 Nov. 2011.

[7] Washington, Jason Lange. “Federal Reserve Might Not Undertake QE3, And It Might Not Help If They Do.” Breaking News and Opinion on The Huffington Post. The Huffington Post, 13 Aug. 2011. Web. 9 Nov. 2011.

Investment’s Role in the Economic Recovery

An interesting take from Greg Mankiw on potential ways to stimulate the stalled economic recovery.  The article makes an interesting juxtaposition between the current economic downturn and the recession of 1982.  What stands out is the stark contrast in the strength of business investment levels in either recovery.  While the stimulus policies and efforts of the government have focused on bolstering the level of consumption within the economy, it has become apparent that federal stimulus has done little to support or encourage the overall level of business investment.  Mankiw believes that this is indicative of a general lack of investor confidence and certainty in the long-term problems facing the country.  As discussion of a third round of quantitative easing heats up, it is important to question as to whether essentially the same strategy a third time will truly do anything to assuage investor uncertainly or help to reinvigorate the economy.

The Rise in Global Inflation: An International Collaboration

As the global economy continues to recover from the recession following the crash of 2007, a troublesome trend of rising in inflation has begun to concern world economic leaders, especially given its timing with unemployment remaining at elevated levels.  The root cause of this problem was a major subject of debate amongst the world’s largest economic countries at the most recent G-20 summit in Paris.  Many foreign countries pointed the finger for this rise at the United States for the interventionist programs the Federal Reserve has recently enacted, most specifically their quantitative easing program or “QE2.”  Federal Reserve Chairman Ben Bernanke countered this point at the meeting by arguing that in fact the elevation in global prices is a result of growth within developing countries and currency manipulation by countries such as China.  The disagreement surrounding this global issue is indicative of the uncertain nature of economic forums, such as the G-20, and their inability to directly influence countries’ economic policies.  Whether the rise in global inflation is more a result of Chinese currency manipulation or U.S. Central Bank policy, the increase in prices is cause for concern in a global economy which remains highly vulnerable given its unemployment levels.

Germany and China are among a number of countries that have been highly critical of the Federal Reserve in recent months, a trend evident at the November meeting of the G-20 held in South Korea.  That meeting came days after the Fed had announced its second round of quantitative easing, a program which was especially criticized given its size and history of debatable success.  In theory, “QE2” was initiated in hopes of keeping interest rates lowered in the long-term to stimulate investment and growth by using a strategy which had been used by the Fed earlier in the U.S. stimulus package.  For this second round of quantitative easing, the Federal Reserve announced that it would again purchase Treasury bonds, this time in an amount of $600 billion.  While proponents of the plan heralded the Fed’s initiative and the merits of low-interest rates to stimulating growth, the program also garnered much opposition both domestically and internationally, a fact that was apparent at the November G-20 meeting.  There, countries accused the Fed of significantly contributing to global inflation and of attempting to lower the value of the dollar in hopes of making American products more attractively priced within the international market.  Yet the criticism of U.S. monetary policies, along with the accusation of currency manipulation as a root cause of increased global prices, were points Chairman Bernanke’s vehemently questioned in his rebuttal to critics of the recovery plan.  Rather than finding the United States’ policies as a direct source of international problems, he instead placed the blame upon overheating within developing economies and deliberate currency devaluation in countries such as China.

Since the announcement of QE2 and subsequent criticism at the November G-20 meeting, Federal Reserve Chairman Ben Bernanke has actively defended and argued against the belief that increased inflation globally is directly linked to this initiative.  “Spillovers can go both ways,” he stated at the most recent summit, “resurgent demand in the emerging markets has contributed significantly to the sharp recent run-up in global commodity prices.”  Additionally, he has indirectly referenced China’s monetary manipulation as an integral piece of the increase, saying “the maintenance of undervalued currencies by some countries has contributed to a pattern of global spending that is unbalanced and unsustainable.”  China’s monetary policy has been greatly challenged in the past due to their strategy of pegging their currency to the United States dollar in an effort to ensure their exports remain competitively priced within the global market.  The recent global downturn and ensuing rise in inflation has only exacerbated the calls for Chinese reform and the U.S. is hardly alone in their criticism of the practice.  While China has loosened their policy recently and allowed their domestic currency the yuan to gain value, it is still viewed as being artificially devalued.  Bernanke, along with numerous other G-20 members, have continued to call for the Chinese to allow their currency to “better reflect market fundamentals” in an effort to transition from an economy based extensively on international demand into one more centered on their own domestic demand.  Yet despite the significant rise in the domestic buying power of the Chinese consumer, China’s reluctance to allow their currency to directly reflect international market valuation has continued to increase trade imbalances and promote and unsustainable economic relationship between China and the world.

Though fervent in his defense of Federal Reserve initiatives, Chairman Ben Bernanke did not attempt to completely clear the United States from blame in the recent inflationary developments.  While criticizing countries which manipulated their currency for increasing trade imbalances and international cash flow, he also called for countries such as the U.S., which are large next importers, to increase domestic saving and balance budget deficits.  Unfortunately, the G-20 countries as a group lack any official ability to sanction or influence an individual country’s economic policy decisions.  Instead, the group must rely on the voluntary agreement of a country to submit and adhere to a G-20 policy or decision.  This is particularly significant when considering Bernanke and many countries’ desire to see countries like China loosen their monetary policy, and countries such as the U.S. to be more responsible and restrictive in their spending.  These idealistic desires, if followed, would certainly promote growth, stability and lower inflation within the international economy, yet the lack of leverage within groups like the G-20 to directly facilitate implementation of such policy means that world powers can continue to remain self-interested first and globally conscience second.  While this may seem more appealing domestically, ultimately, it also works to perpetuate issues such as the current inflationary problem dragging on global recovery efforts.

Global inflation, which has increased prices in places like China over 5% in the last year, is becoming increasingly disconcerting for the economic leaders of the world.  As exhibited especially at the two most recent G-20 summits, the cause of this rise is both uncertain and highly contentious.  Many countries feel that the United States’ domestic bond-buying programs, such as the second round of quantitative easing, have directly influenced the elevation of global prices, a claim which is far from unanimously agreed upon.  Others, such as Federal Reserve Chairman Ben Bernanke, argue that the problem is hardly a result of a single country’s actions but rather a result of the rise in demand within developing economies instigated by currency manipulation and fiscal irresponsibility amongst global economies.  While Bernanke’s calls for an increase in global consideration and cooperation amongst the G-20 members are admirable, the group’s lack of tangible power to implement these policies has continued to make international agreements frustrating and difficult to enforce.  Ultimately, this reality means that finding a solution to international economic problems within the tentative global recovery remains difficult, a fact illustrated by the current issue of global price inflation.