Saturday, November 13, 2010

Known unknowns - impact of QE?

The debate about the likely economic impact of quantitative easing (QE) is another example of how the final outcome of any economic decision can go any which way, depending on the specific confluence of factors.

In this case, the magnitude of stimulus boost to the US economy provided by the QE will depend on the changes brought about in long-term interest rates, value of the dollar, and equity market valuations. This impact will be felt through three channels

1. Encouraging business investments (by way of lower bond yields and higher share prices)
2. Favoring household consumption (through wealth effect caused by lower debt service costs and higher asset prices)
3. Increasing exports (by way of weaker dollar)

Chris Dillow feels that "investment isn’t very responsive to asset prices, nor exports to exchange rate". The final outcome will be a function of the interaction of all these with the "confidence fairy" effects. The strength of the "confidence fairy" is determined by the "animal spirits" manifested in business confidence and consumer beliefs, tempered by the activism of "bond-vigilantes" and the business investment inertia of the real option theory (wherein, when faced with uncertainty, people have more incentive to hold onto the option to invest rather than to exercise it).

As can be surmised, there are too many imponderables in the aforementioned equation for anyone to confidently predict the final outcome of a related policy prescription. What would be the respective impacts of interest rate decline on business investments, domestic oncumption due to asset market increases, and exports because of declining dollar? How active (or inactive, as is the case now) will be the "bond-vigilantes"? What will be the combined interaction effect of the macroeconomic factors with the "confidence fairy"? Given the uncertainty and the multiple actors involved (other countries, especially China, EU, and other major emerging economies), it may not be possible to answer these questions a degree of assuredness ex-ante.

In the circumstances, the best possible option is to evaluate the costs and benefits, risks of doing and not-doing, and taking decision accordingly. Given the perilous state of the US economy, the risks of not conducting monetary accommodation appear to far out-weigh the risks of doing so.

QE will have an impact of raw material prices too. Commodity prices will be affected through three channels

1. The possibility of inflationary pressures being created by expansion of the monetary base and consequent money supply growth.

2. A share of the money finding its way into the commodity markets and increasing commodity derivatives market speculation. This will surely have some impact on the actual commodity prices.

3. The weakening dollar will exercise an upward pressure on raw materials since their international market prices are generally denominated in dollar values.

In an excellent recent post, James Hamilton cautioned against QE by pointing to a close co-relation between monetary expansion and commodity prices. He feels that "there is a pretty strong case for interpreting the recent surge in commodity prices as a monetary phenomenon". He writes that even as Fed attempts to forestall a Japan-style deflation, it also "needs to watch commodity prices as an early indicator that it's gone far enough in that objective". He claims that his point of costs exceeding benefits would be when oil prices move above $90 a barrel.

On a related context, Nick Rowe has a nice post on Tobin Q, and how its rise would boost economic activity. Tobin Q, named after James Tobin, is the ratio of the market value of a firm's assets, as measured by its stock and bond prices, divided by the (actual) replacement cost of those same assets. Businesses invest if "buying one extra bulldozer adds more to the financial value of the firm than it costs the firm to buy it". Prof Tobin had argued that loose monetary policy would boost share and bond prices and thereby raise Q, and so make new investments attractive.

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