Next round of quantitative easing a last resort with many consequences

By The Capital Management

“Quantitative” refers to the fact that a specific quantity of money is being created; “easing” refers to stimulatory monetary policy. Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements, to indirectly influence the supply of money. In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain the level of money supply desired by the central bank, and so quantitative easing is employed to further boost the amount of money in the financial system. This is often considered a “last resort” to increase the money supply. The first step is for the central bank to create more money out of nothing by crediting its own account. It can then use these funds to buy investments like long-term government bonds, mortgages and other instruments from financial firms such as banks, insurance companies and pension funds, in a process known as “monetizing the debt.” By doing so, the central bank can effectively push down long-term interest rates and at the same time increase money supply in the hope that bank can increase lending and help revive the economy. It was first deployed in Japan when the deflation spiral seemed out of control during March of 2001 through March of 2006 with some success. After Lehman Brothers filed for bankruptcy on Sept. 15, 2008, the credit market froze, banks were holding huge amount of mortgage related illiquid assets and low interest rate just wasn’t enough to stimulate the economy. The U.S. Federal Reserve started quantitative easing measures and along with other stimulus programs pulled the economy out of recession. But the recovery has stalled since the second half of this year, and chairman Ben Bernanke hinted that he stands ready to take further action when it is deemed necessary. The market has since priced in such expectation that on next FOMC meeting on Nov. 2 and 3, Quantitative Easing 2 will be officially announced. We do not think it will be as effective as the first Easing because banks are now awash with money to lend, and the yield of the 10-year note is only 2.38 percent at 50-year low with very little room to go down further. The financial markets welcome another round of QE, the long-term interest rate will stay lower for longer, homeowners who refinance will have extra money to spend, and corporations can issue new debts with lower interest rates. The downside would be higher inflation expectations, lowering interest income for savers. Another consequence is the already weakening dollar is creating chaos among developed and emerging economies where their currency is gaining unwanted strength at the time when every nation on earth is trying to export their way out of recession or to grow their economies. Finally, the Fed does not create jobs, corporations do.

As long as the economy is stuck in low gear, companies are not keen on hiring and it will take some time for Quantitative Easing to take effect. You may ask, what is the size of the balance sheet held by the Federal Reserve now? As of Oct. 6, the asset on the balance sheet is US$2.35 trillion or about 16.5 percent of the GDP.