Quantitative Easing - Should Countries Embrace it during Crisis?
Posted in Finance Articles, Total Reads: 2844
, Published on 24 January 2014
Quantitative Easing or (QE) is one of the most controversial terms ever created. It is one of those buzzwords that has exhaled from the blessed or sacred walls of Federal Reserve in Washington DC to all parts of the country throughout the world, has unfathomed ramifications for commerce. It is generally used for monetary supply by buying of bonds (corporate, or government) from the market to promote increased lending by reducing interest rates. This helps the economy reignite by the increased amount of lending and borrowing.
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QE comes to rescue when the interest rates come close to zero. At zero interest rates the effect of it, on regulating the economy becomes dulled. But banks need to make profit, so during the lull times in the market, the gap between the official interest rates and the one faced by companies and consumers may rise, because the lenders would want higher returns for the risk of granting loans when the markets are tough. Thus QE policy used by the central banks creates new money in the economy to boost the lending.
Impact of QE
There are a lot of benefits to implement QE. With the implementation of QE a lot of cash is pumped in by the central bank. So the financial investors give the received cash to the borrowers as loans. This in turn will help the consumers and businesses grow and spend more as the interest rates slowly drop. With the purchase of long term bonds, the bond price increases, the bond yield decreases, hence the overall financial cost also decreases.
What is QE?
United States Federal Reserve is spending $85 billion in buying bonds in the hope to support country’s economic conditions. It adds liquidity to US market and stimulus by lowering interest rates which provide helping hand to businesses.
With the implementation of QE, the home currency also gets devalued which in turn impacts the economy making the export goods more competitive. Therefore increase in government expenditure will lead to the increase in the consumption rate, which fosters the job creation as the demand for goods will increase, leading to increase in employment, ultimately leading to economic vitality.
History of QE and its Myth
When the world was undergoing economic crisis, the G-4 economies (US, UK, The European Union, and Japan) which had control of most of the world economies came out with the QE policy. These countries had near to zero interest rates but still the economy and the industrial sector looked very slow. So the with QE ,the central bank of these countries started buying a lot of financial assets such as mortgaged backed securities which pumped in a lot of money into the banking system. This was done as explained earlier to expand the industrial sector and encourage consumption which in turn would help in creation of jobs.
There are a lot of Myths about QE!!
First Myth: It’s all about printing money
Generally people tend to believe it all about printing money. This is because the central bank buys those bonds by crediting banks accounts with Fed reserves that did not exist before. But it actually doesn’t do anything to increase the amount the money in the circulation. When the government buys bonds from banks, it merely raises the price of that particular type of bond and lowers the interest rate. This lowering of interest rates encourages consumers to take out loans but it does not lead to more money in system, unless banks create more money through making loans.
Second Myth: It is lead to inflation in the economy
QE is not rising prices thus creating inflation in the economy. It all about managing the long term interest rates in the same way as the short term interest rates are managed. The short term interest rates being too low for a long period of time will actually encourage a lot of spending from consumers. This overspending on consumer durables will eventually lead to price hike. But idea of keeping the interest rate too less does not make any sense as the economy is low which is evident from the high rate of unemployment.
Third Myth: it will lead to increase in stock prices:
The central bank buying more of bonds will increase the bond prices. It will not only make the prices of the bond to be higher, at the same time the interest rates will also lessen making it unattractive for investors. Thus it will lead to investors investing more on stocks rather than on bonds to gain a higher margin. The increase in the purchase of stocks, the prices of stocks also increases which may be misleading to many that the stocks are good enough to buy.
Driving out the myths about the potential benefits of Quantitative Easing!!
QE, more than a boon it’s a bane in the current economic conditions. This explanation will bring to your notice the adverse effects of implementing the QE in the crisis economy.
What if the consumers are indebted more?
QE may not be able to achieve the desired result of boosting the economic growth because if the consumers are already in debt they will not be taking more loan or borrow more money; it does not matter how cheap the loan is. This will adversely effect of t he consumer spending, thus the entire virtuous cycle of more demand in the market leading to increase in more jobs and more growth in the economy will get effected.
Banks invest heavily in shares and assets. They hardly make any investment in the business. QE has not been lending it more into productive assets like factories, plants and equipment. It has in fact stimulated the short term risky investments and has encouraged more speculation.
Not able to stimulate economic growth and Employment
QE has been in effect since the 2008 and since then the policy has not generated enough employment or economic growth. Britain and European Countries are stuck in inflationary recession, similarly US is also facing mild inflation. This means high unemployment rate and high inflation is slowly moving up.
Besides even if QE does help in with a lot of investment it will not able to create much jobs in the market. Firstly because the unemployment in the market might be because of the mismatch of the skills, skill requirement of jobs and the skills of the unemployed. Such kind of monetary policy will have no effect on the structural unemployment. Secondly because the unemployment rates have been high in the previous years it will be difficult to come out of those backlogs and the improvement in it will be a little sluggish.
Effect of Ample Dollar liquidity on the emerging countries
The effect of ample dollar liquidity would as well spread beyond The United States, as most of the emerging countries’ currencies are pegged to the US dollar. The effect will be because of the inflexible exchange rate policies. Thus even if the countries that allow their currency to appreciate, do it at their own risk, risk of asset bubbles (because of the cheap money and higher yield).
QE has flooded liquidity in emerging economies thus resulting in a direct correlation of investors confidence with Fed’s policies. The moment there is a talk of tapering the QE, the market sentiment in emerging economy gets disturbed and investor start flooding back to US. As most of the emerging economies are currently having high current account deficits, hence it puts a lot of downward pressure on the emerging currencies.
QE has failed to achieve its objectives. Instead of focusing on the improvement of unemployment rate and regaining the lost economic stability, it has failed to convince the companies to hire and households to consume more.
Moreover Lower Interest rates during QE means low returns on investments, so QE’s country (like US ) becomes less attractive place to invest and the same money is invested in emerging economies where interest rate is high and returns are better. The money is used for development of other economies rather than for what it was meant for.
In days of crises it is important to stimulate “Constructive Demand” rather than to boost the demand with the help of the QE policy. It is important to boost the consumers’ confidence by improving the macro economic conditions rather than by pumping in more money through fixed income markets.
This article has been authored by Gautam Malhotra and Surojeet Mukherjee from Great Lakes
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