Sunday, September 16, 2012

QE - Unbounded

This article of mine was published in Hindu Business Line on September 16, 2012. Link:

The Federal Reserve with its latest policy announcement of buying 40 billion USD worth of MBS securities without specifying any time frame has provided a shot of morphine to the wandering markets. The price reaction on the long dated MBS bonds, stocks and commodities has been nothing short of stupendous but certainly not unprecedented.
However before getting sucked into the bullish bandwagon it’s important to understand the dynamics involved in the QE operations and to be clear of what the Fed objectives really are and how successful can it be in achieving them.
First there is a misconception or rather a folklore among large number of people and even many in the financial industry that a QE tantamounts to printing of money and hence can lead the world into some kind of hyperinflationary tailspin something like we saw in Weimar Germany or a modern day Zimbabwe, the reality is far from it. What America is witnessing today is something that Japan has been undergoing for the past 2 decades. It has seen zero interest rates, QE programs that involved not only buying JGB’s (Japanese government debt) and other mortgage and corporate debt but also Index futures. However inspite of all this the Japanese stock market is almost a fifth of its peak and the economy chugs along in and out of the negative growth territory.
The reason for this is that under the current fiat monetary setup, it is the loan operation conducted by the banks i.e. banks giving loans to people, corporates and governments is what creates the money supply. In essence when someone approaches the bank for getting a loan then under the prevailing system the banks create credit out of thin air and lend it to the borrower which is simultaneously deposited in the bank account. The loans constitute an asset on the banks’ balance sheet and the deposits an equivalent liability. So please note that worthy borrowers and investment opportunities are critical in boosting the credit and thus money supply in the economy.
Talking from the perspective of “commercial banks” what the Fed QE2 earlier and now QE3 operation would do is to remove some of these assets which were treasuries in case of QE2 and Mortgage backed securities in case of QE3 with another asset which is of the shortest duration i.e. US dollar. This in no way would increase the banks’ ability to lend as that is not a problem to start with today atleast in US or in other words the banks today are not reserve constrained. The only reason why QE1 was so phenomenally successful was because at that time during the peak of the financial crisis, the banks were reserve constrained and the QE operation at that time provided the banks with the much needed reserves. Infact from the perspective of banks the QE is pretty similar to the Open Market Operations that Central Banks across the world constantly engage in with some subtle differences:
-          To start with the investment banks and funds are generally kept out of Open Market Operations
-          While the securities are temporarily removed from the bank’s balance sheet in Open Market Operations, they are permanently removed incase of QE
-          More importantly the open market operation is done to remove liquidity pressure i.e. provide the banks with adequate reserves but the QE is being done even when banks don’t have a problem of reserves
Having said that the Fed really aims to achieve two objectives with these policies namely reducing the interest rates and boosting consumption as it believes that higher asset prices would make the consumer feel richer and thus he would be more prone to increase his consumption.
Today not just banks but also several large and small investment funds also hold a lot a of MBS and treasury paper, this Fed operation would remove these assets from their books as well which would then enable them to either buy more of these assets or invest in other corporate bonds, stocks etc. thus boosting the asset prices atleast in the short term or in other words reducing the interest rates on bonds and other securities. Interest rates are definitely one of the key components that determine the demand for credit and thus influence the money supply in the economy. However apart from interest rates there are other factors as well that determine the credit demand which include demographics, investment avenues and opportunities as well as existing level of debt in the economy. So with interest rates already at record low any further reduction in the rates is not going to boost the credit demand until the existing levels of debt which is the single biggest problem in the US economy is allowed to liquidate. The deleveraging of the US consumers and various sectors of the economy especially the financial sector is critical for any market rally or US recovery to be sustainable in the future.
This is because while the consumer and various sectors of the US economy de-lever i.e. the credit growth slows down or even goes in negative, the money supply growth would not be sufficient to keep asset prices elevated and thus any short-lived asset market rally would take the wind out of the Fed’s objective to boost consumption.

So to counter any decline or slowdown in credit growth and thus the money supply, the US government is constantly running annual deficits in excess of trillion dollars. Just so that the annual trillion dollar additional government debt doesn’t overwhelm the system, the Federal Reserve will constantly engage in its bond buying exercise and thus try to keep the bond and stock markets afloat. This has although not been sufficient to take the economic growth to new highs but , the misallocation and thus destruction of the resources in the real economy as result of this wasteful and distributional nature of government spending continue thus ensuring that the next fall would be even bigger.

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