Mitigation, Mystique or Mistake?

The main QE objective is to keep interest rates at rockbottom levels, but its impact and influence spreads far wider

By Echelon.

Published on November 10, 2013 with No Comments

NOV MH

The more I study ‘quantitative easing’ (QE), the less I understand it. Neither its goal nor its most-feared danger seems to be materializing. The biggest monetary experiment in history may be little more than a giant placebo. Every month under QE’s current phase, the Federal Reserve (or ‘Fed’), America’s central bank, buys $ 85 billion in long-term government debt (Treasury bonds or T-bonds) and mortgage backed securities (MBSs). It finances these purchases by simply crediting its own account with magically-conjured new money, which it then uses to buy the T-bonds and MBSs. With a worried view of the economy, the Fed hopes QE will nurture recovery or at least forestall renewed recession.

Comparable QE policies currently prevail from central banks in Japan, the United Kingdom and the European Union. In a surprisingly short time, QE has become a key anti-recession strategy throughout much of the developed world. It substitutes for stimulus via public spending, as governments hesitate in the face of prolonged unsustainable deficits. Among other indicators, QE’s proliferation suggests that the world economy has stumbled into long-term structural stagnation. Many observers praise the Fed’s early-phase QE between 2008 and 2010 for ameliorating the U.S. financial emergency through loosened credit. Applause is more muted for QE as an ongoing program of economic stimulus. Monetary stimulus has been analogized to ‘pushing on a string’ even in normal times and these are not normal times.
The main QE objective is to keep interest rates at rock-bottom levels so as to stimulate borrowing for new business investment and home purchases, thereby promoting recovery. Fed T-bond purchases can reduce interest rates in two ways. First, it puts cash into the hands of T-bond sellers like banks, thereby increasing the active money supply, at least if the banks lend this cash out rather than holding it or making non-loan investments. With money more abundant, less interest can be charged to lend it: interest rates fall correspondingly.

Second, Fed purchases bid up T-bond re-sale prices, thereby reducing their ‘yield’ or effective interest rate when paid off at maturity. (Regardless of its cost when purchased originally from the government (let’s say $85), a T-bond that will pay $100 when redeemed at maturity carries an effective yield of 25% (20/80) if bought for $80 in the re-sale market but only 11% (10/90) if bought for $90). Falling T-bond yields push general interest rates downward because investment money migrates away from safe but low-yield T-bonds and starts competing elsewhere for borrowers who will pay interest on new loans. As more potential loan capital chases the limited supply of sound lending opportunities, borrowers bid down what lenders can charge them in interest.

nov mh numbersThe hope is that low interest rates will stimulate corporate borrowing for expanded production, thereby fostering growth. The problem is that corporate borrowing has not in fact picked up much. Corporate America is already sitting on piles of cash. Its failure to expand production stems not from capital scarcity but from poor prospects of securing profits through increased output. The buyers are simply not there: American households have cut spending levels drastically since the 2008 recession as they struggle to pay down excessive mortgage and credit card debt. Weak borrowing despite record low interest rates explains why QE’s stimulative effect has been so feeble. It also explains why the most-feared QE side effect— inflation—has failed to materialize. Critics worry that inflation can be sparked by increasing the active money supply, but QE has not actually done that. Cash created by the Fed to finance QE purchases is not circulating through stepped-up lending but is instead sitting idly in bank vaults. Or worse…
In theory, the Fed’s MBS purchases foster job creation as well, in somewhat roundabout fashion. MBSs essentially represent collection rights on multiple mortgages (typically many thousands). Lenders selling these mortgages get cash promptly in hand instead of waiting through the durations of the loans for repayment and running the risk of defaults. For their part, buyers of packaged collection rights (MBSs) exchange their cash for chances to secure repayments on multiple mortgages.

Because the original lenders can reduce their risks through sales of mortgages in MBS markets and quickly replenish their cash supplies for further lending, interest rates on home loans supposedly fall. This can stimulate home-buying. By pushing MBS prices upward, Fed purchases stimulate the MBS market and thereby encourage low mortgage rates and increased home-buying. This fosters job creation through revival of the critical and long-moribund construction sector. So goes the theory, but proof in the form of a revived housing sector is pretty slim. Debt-heavy American households cannot afford new mortgages, no matter how low the rates. Four side effects of QE merit attention.First, QE’s promise of prolonged low interest rates seems to have fueled a boom in U.S. stocks: nice for the rich folks who own them. The question is why. Markets presumably feel that low interest rates will stimulate growth, but any such growth depends on activation of QE cash for expanded production and on housing sector revival, both of which are not in fact happening. Markets may be floating on a bubble of false assumptions. Ironically, however, this may itself produce a stimulative ‘wealth effect,’ whereby those with fattened stock portfolios start spending more money.

Second, QE may be affecting currencies of export-dependent developing countries, including Sri Lanka of course. Critics warn that QE pushes those currencies upward against the dollar and other hard currencies. (In fact, the dollar has gone up against developing country currencies since 2008, when QE began. Weak as the U.S. recovery has been, America remains an attractive investment venue compared with even worse economies elsewhere. Investors therefore keep buying dollars, maintaining its value against other currencies.)

Low interest rates in QE countries have prompted capital flow to developing markets as both ‘hot’ money and direct borrowing. Hot money flows as ‘carry trade’ arbitrageurs borrow at low QE-influenced rates in order to lend out at higher rates in developing markets. Direct borrowing occurs as firms in developing markets secure low interest rates from lenders in QE countries. Both flows exert upward pressure on developing market currencies. On its face, capital inflows should be good news of course, but hot money is always potentially destabilizing and low-interest direct borrowing may divert scarce developing-country resources toward dubious priorities like surplus office buildings, condos and shopping malls.In an emerging irony, meanwhile, developing countries like India and Brazil now express alarm that their currencies have been moving downward too fast due to weakening exports and other woes. Far from criticizing QE, they are now worried that if the U.S. economy keeps growing the Fed might start reducing or ‘tapering’ QE. This could send their currencies into freefall as loose change heads for America in hopes of rising interest rates. It’s a strange day when export-sensitive economies pine for weak U.S. growth: welcome to QE Land, the latest attraction at Structural Stagnation World! After wobbling through the summer on mere hints of tapering, developing country currencies firmed up in September when Fed chairman Ben Bernacke announced that tapering would not come soon because U.S. growth appears weak.

Third, QE’s low interest rates reduce incentives to save and penalize households who have saved already in hopes of earnings from interest. Long-term implications are anybody’s guess, but positive ones seem unlikely. Fourth, with a double scoop of irony: instead of lending for low QE returns, U.S. banks are now using their QE cash for the same complex speculation that brought us the 2008 crisis in the first place.

A graduate of Harvard Law School, Mark Hager lives in Pelawatte with his family. He consults on legal, writing and negotiations challenges.

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