Thursday, November 4, 2010

The dangers of QE 2.0 for the world economy

Even as President Obama suffered losses in the Congressional elections, the Federal Reserve voted in the opposite direction to move ahead with further monetary accommodation through a second round of quantitative easing.

As expected, the Federal Open Market Committee (FOMC) decided to go ahead with a $600 m monetary expansion through asset purchases. The FOMC outlined the reasons

"(T)he pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters."

And then the proposal to expand the Fed's holding of securities so as to promote a stronger pace of economic recovery and lower the elevevated unemployment rate,

"The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month."

About the economic prospects for the days ahead,

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

This action will further increase the Fed's already swollen balance sheet and is expected to lower the rates on long term securities (and consequently coporate and mortgage bonds), thereby encourage business investment related borrowings. Coupled with the Fed's ongoing program, started in August, of using proceeds from its mortgage-related holdings to buy additional Treasury debt (at a rate of about $35 billion a month, or $250 billion to $300 billion by the end of June), the total Fed QE expansion will be $850 billion to $900 billion.

Economix has a list of economists who have supported and opposed such monetary expansion. WSJ described it the "riskiest chapter yet in (Fed's) attempt to lift the U.S. economy out of its toughest economic environment in generations". Reactions here.

It is undoubtedly true that the US economy needs more monetary accommodation now. And economic growth in the US and other developed countries is critical for the world economy. However, the monetary expansion in the US could generate potentially harmful and even disastrous consequences for the world economy due to certain actions and trends elsewhere.

Monetary accommodation in the US will have two important and immediate external effects - put downward pressure on the value of dollar and amplify the current trend of capital flows into emerging economies. Both in turn have the potential to exacerbate already serious economic distortions, especially when it interacts with policies followed by other countries.

China's refusal to let its currency appreciate in relation to the dollar ensures that renminbi will also go down with the dollar. This will adversely affect the competitiveness of other emerging economies - who compete directly with China in many export markets - and force them into intervening more aggressively in the currency markets.

This will in turn exacerbate the current alarming capital flow trends into emerging economy financial markets. Further, any reduction in long-term Treasury rates coupled with the recent increases in interest rates across many emerging economies will widen the interest rate differential and add to the forces driving capital inflows into those economies. Such inflows, in turn, generate upward pressure on the local currencies.

The closed positive feedback loop arising from the interaction of these two trends can generate other distortions. For fear of unleashing inflationary pressures from such massive inflows, emerging economy governments would be forced into sterilizing the inflows. This in turn will increase the supply of their Treasuries, with attendant cost of holding them.

More damagingly, such inflows, especially at a time when these economies are back to their pre-crisis growth rates, have the potential to generate asset mis-allocation problems. Equity markets, most certainly everywhere, and real estate, in many emerging economies, are showing enough signs of froth and bubble. All such distortions are of greater concern given the uncertainties that surround growth in the developed economies and its close relation with the economic fortunes of many export-dependent emerging economies.

A damaging intersection of all these trends, especially if the underlying forces build-up to a critical mass, have the potential to trigger off currency and trade wars, marked by protectionist and retaliatory actions between countries. It also has the potential to unleash a movement towards imposition of capital controls, all of which could set-back the process of economic liberalization and global financial market integration many years back.

Since monetary accommodation in the US is essential for the US to give itself a fighting chance for recovery, the only chance of limiting the adverse impact from the aforementioned scenarios is for sensible and far-sighted macroeconomic policies from countries across the world. Most importantly, China will have to drop its weak-yuan policy and let its currency appreciate with respect to the dollar. More than the positive impact on US-China economic balance sheet, it will be more beneficial for the rest of the world, especially the other emerging economies. In the absence of any erosion of trade competitiveness, they will have no reason to intervene in the currency markets with its attendant dangers.

Equally important, emerging economies should engage in counter-cyclical macro-prudential regulation to stabilize their financial markets. Such regulation, especially on the real estate and equity markets, are likely to be more effective than knee-jerk capital controls. Such actions will mitigate the potential asset mis-allocation problems that could arise from massive hot-money flows and dampen the resultant financial market cycles. Unfortunately, the possibility of these aforementioned steps looks remote.

Update 1 (4/11/2010)

As expected, some emerging economies have reacted with dismay to the Fed decision and criticised it as endagering them.

Update 2 (6/11/2010)

With some signs of recovery taking hold, the Bank of England and ECB have decided to leave their record low interest rates in tact. The British bank left its bond purchasing program at £200 billion, or $322 billion, and its main interest rate at 0.5%, while the ECB left the rate at 1%.

Update 3 (11/11/2010)

Primer on QE from Felix Salmon.


smplcv said...
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Parag said...

Most Americans have absolutely no idea how fragile the world financial system is right now. Once the rest of the world loses faith in the U.S. dollar and in U.S. Treasuries this entire thing could completely unravel very quickly.

The Federal Reserve is playing a very dangerous game. They are openly threatening the delicate balance of the world financial system.
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