2012

Quantitative Easing A Blessing or a Curse?

CRISIL Young Thought Leader 2012

Quantitative Easing is the Government policy to increase the money supply by injecting liquidity into the economy by buying Government assets back from the market. It increases the capital within the financial sector, and therefore, increases the amount which banks lend to consumers and small businesses, in an effort to promote economic growth. However, it is usually done when interest rates are already extremely low and there are no other measures which can be taken. An additional "by-product" is huge risk of inflation increase and loosening the risk aversion, which in turn, fuels the global money migration to the most risky assets. Share your views if it is a blessing or a curse given the current economic conditions.

Submitted by: 0 Anusha Magavi

Quantitative easing is a monetary policy tool used by the central bank in which it purchases long-term government securities to reduce the interest rates. This supposedly reignites the economy by spurring lending and borrowing. However, there are good reasons to suspect QE might not work and to fear it will wreak additional damage. First, highly indebted citizens will not further leverage their accounts to spend more defeating QEs purpose of accelerating consumption. Second, if the new money is used to buy assets abroad, or hoarded by the banks, then it will not help the economy. Third, it has failed to stimulate economic growth since investment spending can be induced through positive economic outlook rather than low interest rates. Neither has it created new jobs as most of the unemployment is structural which cannot be reduced through QE. Fourth, dollar devaluation has led to capital flight out of the domestic economy which neither forms any tangible investment nor creates assets. It only creates debt, which is multiplied through credit insurance, default swaps and various computerized forward trades. Fifth, government overspending will cause additional problems when all the purchased bonds are offloaded in the market. Sixth, it hurts pension fund schemes by reducing gilt yields, thus worsening the retirement crisis. Due to lower annuity rates, the pensions will reduce which in turn damages growth because these pensioners have less to spend. Seventh, it increases the propensity to issue new debentures. Whether these proceeds are applied to corporate stock repurchase programs or in enhancing dividend yield, they have potential adversarial consequences. Increasing leverage in todays uncertain economic times will jeopardise the financial stability of the corporation by increasing its future cost of capital. Hence, monetary policy, in and by itself, will neither re-establish sustainable economic stability nor restore confidence, constructive demand and optimism. Fiscal measures should be taken to encourage investment, while simultaneously carefully exacting budgetary reductions to secure sustainable economic recovery.

Table of Contents
Introduction to Quantitative Easing ........................................................................................... 3 Benefits of Quantitative Easing ................................................................................................. 3 Dispelling the Myths of the Potential Benefits of Quantitative Easing ..................................... 3 Effect on Consumer Spending................................................................................................ 3 Mal-investment....................................................................................................................... 3 Failed to Stimulate Economic Growth and Employment ...................................................... 4 Devaluation of the Dollar ....................................................................................................... 5 Government Overspending .................................................................................................... 6 Hurts Pension Funds .............................................................................................................. 6 Propensity to Access Fixed Income Markets ......................................................................... 7 Conclusion ................................................................................................................................. 9 The Bottom Line ........................................................................................................................ 9 References ................................................................................................................................ 10

Table of Figures
Worsening of the Misery Index of USA .................................................................................... 4 Failure of Earlier QE Measures by the Fed ............................................................................... 4 Required Reserves and Excess Reserves ................................................................................... 5 Weak Correlation between US Dollar and Net Exports of the US ............................................ 6 Relation between the Pension Fund Reserves on the Balance Sheet of US Households and the Interest Rates on US Government Securities ............................................................................. 7 Share Buybacks and Dividend Payments in the US are increasing whereas Treasury Yields are decreasing............................................................................................................................. 8

Introduction to Quantitative Easing

Quantitative easing has, by far, been one of the controversial terms ever created. Quantitative easing is a monetary policy occasionally used to increase the money supply in the economy (when zero bound has not produced the desired effect) by purchasing government securities from the market, hence flooding financial institutions with capital and increasing their lending capacity and liquidity.

Benefits of Quantitative Easing

Quantitative easing is supposed to benefit the economy because the cash that the FIs receive from the central bank for the assets can then be loaned to borrowers. Hence consumers and businesses will borrow and spend more as interest rates drop. Through the purchase of longterm government bonds, the central bank decreases yields and, consequently, overall financial costs. QE also impacts the economy by devaluing the home currency hence making export goods more competitive. Therefore it is believed that the increase in government expenditure will lead to increased consumption, which will further increase the demand for goods and services, thus fostering job creation and, ultimately, creating economic vitality. Since the global financial crisis, quantitative easing has been used by the Bank of England and the Federal Reserve to try to revive consumer spending and economic growth. As of September 2012, the Bank of England had committed a total of 375bn to QE, while on 14 September the Fed said it would spend a further $40bn per month. This was on top of the $2.3tn the Fed had already put into QE since 2008.1

Dispelling the Myths of the Potential Benefits of Quantitative Easing

QE is more of a curse than a blessing given the current economic conditions. This dissertation analyses the adverse effects of the QE measures with special emphasis on the US economy.

Effect on Consumer Spending

QE may not achieve the desired result of boosting economic growth because if the citizens are highly indebted they will not borrow more, no matter how cheap the loan is.

Mal-investment
Banks and other investors may take the money and stick it into assets like shares and commodities, rather than lending it for more productive purposes like business investment. So far, QE has not led to investment in factories, plant and equipment. Rather, it has stimulated short-term risky investment and encouraged speculation in equities, gold and other assets.

BBC Business News, October 3, 2012; http://www.bbc.co.uk/news/business-15198789.

Failed to Stimulate Economic Growth and Employment

QE has been going on since late 2008 and since then the policy has neither generated economic bounce nor created new jobs. Instead Britain and Continental Europe are stuck in an inflationary recession, similar to the 1970s, while the US is facing a mild inflationary revival. This means that unemployment remains high plus inflation is creeping up.
Figure 1: Worsening of the Misery Index of USA 14.0 12.0 10.0 8.0 Percent 6.0 4.0 2.0 0.0 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12
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Source: FRED database of the Federal Reserve Bank of St. Louis Figure 2: Failure of Earlier QE Measures by the Fed 15 10 5
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Source: Bureau of Economic Analysis, Federal Reserve Bank of St. Louis

Almost all the increase in the supply of credit associated with QE is held by banks as excess reserves rather than making loans. Hence, the effect of QE on interest rates is small and limited to an announcement effect.

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Figure 3: Required Reserves and Excess Reserves 1800 1600 1400 1200 1000 800 600 400 200 0 Apr-05 Dec-06 Apr-10 Mar-03 May-07 Mar-08 Dec-11 May-12 Aug-03 Aug-08 Jun-04 Oct-02 Oct-07 Jun-09 Nov-04 Nov-09

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Required Reserves

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Source: Board of Governors of the Federal Reserve System

Investment spending depends more on the economic outlook than on interest rates. So further reducing the historically low interest rates may not stimulate aggregate demand. Correspondingly, there is a hardly any effect on output and, hence, employment. Besides, even if QE did affect output significantly, its effect on employment would not be substantial due to two reasons. Firstly, part of the current unemployment is due to a mismatch between the skill requirements of jobs and the skills of the unemployed. Monetary policy cannot do much about structural unemployment. Secondly, post-recession employment growth could be slow irrespective of policy actions since it had been sluggish even in the previous two recessions.2

Devaluation of the Dollar

QE will have the effect of devaluing the dollar and so it is assumed that US exports will become more competitive leading to economic growth. However, historically there has not been any strong correlation between declining currency and rising exports, and even if it were to occur, it would be temporary. If the value of the dollar reduces, all the inputs will become more expensive which will offset any advantage from dollar devaluation.

Thornton, Daniel L. (2010). Would QE2 Have a Significant Effect on Economic Growth, Employment, or Inflation?, Federal Reserve Bank of St. Louis Economic Synopses, No. 29. http://research.stlouisfed.org/publications/es/10/ES1029.pdf.

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Figure 4: Weak Correlation between US Dollar an d Net Exports of the US 800.0 700.0 Index 1997:Q1 = 100 600.0 500.0 400.0 300.0 200.0 100.0 0.0 Feb-06 Oct-03 May-04 60.000 40.000 20.000 0.000 140.000 120.000 Index January 1997 = 100 100.000 80.000

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Source: Bureau of Economic Analysis, Federal Reserve Bank of St. Louis

Moreover, US dollar devaluation has forced investors to switch their money into other currencies, thus, causing global instability. Since 2008, the Japanese yen has appreciated by 56 per cent against the US dollar and the Singapore dollar by 25 per cent. The surge in the yen has led to continuous recession in Japan, while flows into Singapore dollars have made it problematic for its central bank to control the money supply. This has encouraged speculation in property and general inflation.3

Government Overspending
Financial repression of bond yields bolsters governments to continue to overspend at an unsustainable rate as they can borrow at below normal rates. The inevitable results, as seen in the fallout of the 2008 crash, are uncomfortable austerity policies and debt repayments that cause recession and social upheaval and riots.

Hurts Pension Funds

QE has driven up the cost of government bonds thus reducing the yield that investors gain by buying them. This has increased pension fund deficits as low bond yields are inadequate to fund members. Also, pension fund managers are forced to buy equities, commodities, real estate and hedge funds that can decline in volatile markets. Since the return on their savings is insufficient, the pensioners, except the wealthy few, are forced to consume less, thus reducing demand in the economy.
3

Behrmann, Neil Adverse Effects of Quantitative Easing Market Sentiment & Lateral Thoughts, October 2012; http://neilbehrmann.net/2012/10/adverse-effects-of-quantitative-easing/.

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Figure 5: Relation between the Pension Fund Reserves on the Balance Sheet of US Households and the Interest Rates on US Government Securities 16000.00 14000.00 Billions of Dollars 12000.00 10000.00 8000.00 6000.00 4000.00 2000.00 0.00 1.00 0.00 4.00 3.00 2.00 6.00 5.00 Percent per annum

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Interest on Government Bonds Source: IMF, Federal Reserve Bank of St. Louis

Propensity to Access Fixed Income Markets

Corporate issuers have an increased propensity to access the fixed income markets to seek lower cost financing as the QE measures of purchasing Treasury securities has reduced their yields. There is also an increase in corporate stock re-purchase programs. The tendency of firms to apply proceeds from their new debentures to re-purchasing company stock indicates the shift to seek ROE in lieu of ROC. Due to increase in the share buybacks, outstanding stock decreases and, if total earnings remain unchanged, EPS increases. Although market capitalization is unaffected, the use of historic P/E multiples for valuation may make the companys stock seem undervalued and, consequently spur investors to purchase stock. The propensity to purchase more stock will distort share price relative to the underlying fundamentals of the company. Thus, firms are concealing the lack of topline growth by reporting high ROE. Another distortion is the application of debenture proceeds to pay dividends which skews the underlying value of a given security. The issuance of new debentures will increase the leverage ratio of a company and, consequently, may increase their long-term cost of capital and weaken overall financial soundness.

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Figure 6: Share Buybacks and Dividend Payments in the US are increasing whereas Treasury Yields are decreasing 200.00 180.00 160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 6.00 5.00 4.00 Percent 3.00 2.00 1.00 0.00

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10-Year Treasury Constant Maturity Rate Source: S&P, Federal Reserve Bank of St. Louis

Similar to corporate issuers, investors are also investing in fixed income securities instead of equity markets due to heightened economic uncertainty and decreasing investor confidence. Also, as interest rates decrease, the price of bonds increase and investors are furthermore attracted to invest. This spurs interest among firms to continue issuing new debentures. Nobel Economist Joseph Stiglitz recently stated that the fear for a double dip recession might be in the near future. If these concerns manifest, corporate yields will increase and Treasury yields will most likely remain low due to existing and future QE measures. Should a double dip economic recession not occur, then inflation will emanate from these QE measures and the Federal Reserve will most likely increase interest rates. With a stagnant economy, this may lead to stagflation. The increase in interest rates will decrease bond prices which will cause the refinancing of debt to be done at a higher cost of capital. Thus, it would be more expensive for corporations to retire their debt.

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Conclusion
QE has failed to achieve its objectives. Rather than achieving top-line growth of firms, decreasing the unemployment rate and regaining economic sustainability, the QE actions have failed to convince companies and households to consume, invest and hire more. Specifically, the benefits (good inflation via higher prices for corporate bonds and equities) were coupled with collateral damage (bad inflation via surging commodity prices). This caused technical market dislocations and made the Fed more susceptible to political attack. Besides, as per the law of diminishing marginal returns, each QE measure will require more money-printing than the previous QE to produce the same effect. Hence, we should now focus on restoring 'Constructive Demand' to overcome today's 'Crisis of Confidence'.4 Else there will be a low propensity for risk which will bolster fixed-income markets. Hence, we need to re-establish optimism among consumers and firms to achieve sustainable economic recovery.

The Bottom Line

So what can we expect next? Quantitative easing is not a magic bullet that will solve our economic issues. In fact, when the central banks finally unload all the bonds they have purchased, interest rates will rise and this will slow down recovery just when it has finally started to take off. Markets would retreat if the economy doesnt show signs of improvement. Hence, fiscal measures should be taken and government expenditure drastically reduced if businesses fail to increase hiring and capital investment. This will help to re-establish sustainable economic stability and restore investor confidence and constructive demand.

Yam, Patrick Epiphinal Economic Times The Huffington Post, November 1, 2011; http://www.huffingtonpost.com/patrick-yam/epiphinal-economic-times_b_1070394.html.

References
Yam, Patrick (2010). Quantitative Easing: A Curse or Blessing?, YAM Media Publications. http://www.yammedia.biz/pdfs/quantitative-easing-a-curse-or-blessing-nov10.pdf Christensen, Jens and Rudebusch, Glenn (2012). The Response of Interest Rates to U.S. and U.K. Quantitative Easing, Federal Reserve Bank of San Francisco Working Paper Series, 2012-06. http://www.frbsf.org/publications/economics/papers/2012/wp1206bk.pdf Hamilton, James and Wu, Jing (2011). The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment, NBER Working Paper, No. 16956. http://dss.ucsd.edu/~jhamilto/zlb.pdf Krogstrup, Signe, Reynard, Samuel and Sutter, Barbara (2012). Liquidity Effects of Quantitative Easing on Long-Term Interest Rates, Swiss National Bank Working Papers, No. 2012-2. http://www.snb.ch/n/mmr/reference/working_paper_2012_02/source/working_paper_201 2_02.n.pdf Krishnamurthy, Arvind and Vissing-Jorgensen, Annettte (2011). The Effect of Quantitative Easing on Interest Rates: Channels and Implications for Policy, NBER Working Paper, No.17555. http://www.tilburguniversity.edu/about-tilburguniversity/schools/economics-and-management/news/seminars/finance/2011/Vissing.pdf Neely, Christopher (2010), The Large Scale Asset Purchases Had Large International Effects, Federal Reserve Bank of St. Louis Working Papers, 2010-018D. http://research.stlouisfed.org/wp/2010/2010-018.pdf Thornton, Daniel (2009). The Effect of the Feds Purchase of Long-Term Treasuries on the Yield Curve, Federal Reserve Bank of St. Louis Economic Synopses, No. 25. http://research.stlouisfed.org/publications/es/09/ES0925.pdf Thornton, Daniel (2012). Quantitative Easing and Money Growth: Potential for Higher Inflation?, Federal Reserve Bank of St. Louis Economic Synopses, No. 4. http://research.stlouisfed.org/publications/es/12/ES_2012-02-03.pdf

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