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What is quantitative easing?
This article appeared in the October 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
This time, QE3 is open-ended with a different strategy.
By Shane Oliver, AMP
After foreshadowing it in recent months, the US Federal Reserve is beginning another round of quantitative easing (QE3), but this time on an open-ended basis until it achieves the growth it wants. The news was greeted positively by investment markets, but many are sceptical and it raises many questions that this article seeks to address. Quantitative easing involves a central bank using printed money to buy government and private-sector securities to pump cash into the economy and boost the rate of economic growth. Normally central banks implement monetary policy by changing interest rates. But when companies and households are focused on reducing debt, interest rates can fall to zero and still growth remains weak as no one wants to borrow. One way to continue boosting the economy is to switch to increasing the quantity of money in the economy: quantitative easing.
The US economy is growing but below the pace needed to sustainably reduce unemployment. Hence the latest efforts from the US Federal Reserve.
Why open-ended QE3 and mortgage-backed securities?
The first two rounds of US quantitative easing focused on buying set amounts of government bonds and mortgage-backed securities (MBS, or pools of mortgages) over set periods. QE3 is different, as it involves buying US$40 billion of MBS a month until there is a "substantial" improvement in the labour market outlook. There are several reasons for the change.
First, government bond yields are already exceptionally low, so the Fed perhaps reasoned it makes sense to focus on reducing private-sector long-term borrowing rates. Focusing on the mortgage market via MBS is a low-risk way of doing so and helping a sector that has been very weak.
Second, by not buying any government bonds, the Fed is less likely to be accused of monetising public debt.
Third, making QE3 open-ended with a US$40 billion monthly rate until it achieves a desired outcome sends a stronger signal to households and businesses that the Fed means business, and avoids the end-point problems of QE1 and QE2, where the economy and sharemarket experienced a soft patch around the scheduled end dates in 2010 and 2011.
The Fed has said it will continue QE3 until the labour market outlook improves substantially. Given it is forecasting the unemployment rate to only fall to 7.6-7.9 per cent by the end of 2013 and 6.7-7.3 per cent in 2014, from 8.1 per cent now, QE3 could last some time; without a stronger response in the economy, possibly well into 2014.
How QE boosts growth
Quantitative easing can boost growth in several ways. First, by pumping money into the mortgage market it lowers long-term borrowing costs, which are important in the US because of the greater use of fixed-rate loans.
Second, it injects more cash into the economy - mostly into the banking system and some of this may be lent out, boosting growth further. So far this has not happened in a big way, but bank lending has at least picked up.
Third, by making it less attractive to invest in risk-free assets such as government bonds and mortgaged-backed securities it forces private investors (for example, fund managers) to invest more in risky assets such as corporate bonds or shares, boosting the supply of capital to businesses.
Fourth, to the extent that it boosts sharemarkets, it boosts wealth, which in turn helps drive spending.
Finally, an increase in the supply of US dollars may reduce the value of the currency and help exporters.
Has QE worked so far?
It is very hard to say what would have happened in the absence of quantitative easing over the past few years, but the likelihood is that without it the US economy would have been far worse. Since the GFC, US households and businesses have sought to reduce their debt ratios following a sharp loss of wealth and more recently a fiscal drag of around 1 per cent per annum as the budget deficit is reduced. QE in 2009-10 and 2010-11 provided an offset to these forces, enabling the economy to at least grow.
The US is a bit like a patient in a coma, with the Fed acting as the drip feed keeping the patient alive. The Fed's liquidity can't heal the economy, but it can support it until it comes out of its coma.
Certainly the US, with 8.1 per cent unemployment, is in far better shape than the EU with 11.3 per cent and where QE has not been aggressively used.
- It is almost inevitable that QE3 will have less of an impact than QE1 and QE2 - for example, borrowing costs are lower and shares are higher. However, there is still likely to be a positive effect:
- It will help push mortgage rates even lower
- A further expansion of bank excess reserves will help continue a gradual increase in bank lending
- By buying low-risk mortgage-backed securities, the Fed will further force investors to take on more risk in their portfolios, such as buying corporate debt or shares
- An increase in the supply of US dollars will probably take some of the upwards pressure off the currency, which helps US companies compete internationally.
Our assessment is that QE3 will probably help boost US GDP growth to 2.5 per cent next year.
What are the costs?
The more extreme fears about quantitative easing have been wrong. There is no sign of the hyper-inflation many feared from quantitative easing in 2009. So far QE has boosted cash and bank reserves, but in an economy with lots of spare capacity this needs to be lent out and spent for inflationary pressures to build. This has not happened, and when it does the Fed can withdraw the stimulus.
The problem with the argument that the Fed should not intervene because free-market forces should be able to run their course, is that it ignores the role of those forces in causing the problem in the first place. And if free-market forces are able to run their course, many innocent bystanders will be adversely affected, as in the 1930s. So there is a case for monetary policy to smooth any adjustment in debt levels.
Finally, there is no doubt that large-scale Fed buying of US Treasuries or MBS is creating distortions in financial markets and it does create uncertainty around what happens when the stimulus is withdrawn. But these costs are justified if quantitative easing heads off tougher economic conditions.
What is the global impact?
QE2 in 2010 created some angst around the world, as it meant countries would either have to accept super easy US monetary policy or allow their currencies to rise against the dollar. This time, the reaction is likely to be more positive given the growth slowdown seen in the emerging world and sharp falls in some currencies such as the Brazilian real. Now the emerging world is more likely to welcome the boost to their exports that may result, and may be more comfortable with further monetary easing (in order to limit gains in their currencies).
Countries with inflation concerns, such as India, may be less inclined to cut interest rates, but the easing bias (to cut interest rates) of countries such as Brazil and South Korea may be enhanced. To the extent it causes global central banks to run easier monetary policies to stop their currencies rising, QE3 helps boost global growth.
The investment implications
There are likely to be several investment implications from QE3. First, to the extent it boosts expectations for growth and liquidity in the economy, it is positive for US shares, just as QE1 and QE2 were, and global shares generally. The chart below shows the relationship between US shares and Fed holdings of US Treasuries and MBS.
US quantitative easing and US shares
Source: Bloomberg, AMP Capital
Australian shares rallied 41 per cent in association with QE1 but received just a 15 per cent boost from QE2 amid worries about high Australian interest rates, the strong Australian dollar and China. Given ongoing worries about China and the strong local currency, Australian shares are likely to remain a relatively underperformer in response to QE3 as well.
The boost to investor confidence is likely to result in a bounce in cyclical shares versus defensive sectors.
Second, as QE3 boosts the supply of US dollars it is a negative for the currency, with both QE1 and QE2 triggering 10-15 per cent falls. But any fall is likely to be limited because Europe and Japan have their own problems, and emerging countries have issues that are likely to cap their currencies.
Third, it is positive for commodity prices on the back of any boost to global growth and as they are priced in US dollars. This was seen with QE1 and QE2, although soft growth in China may limit the upside this time around.
US quantitative easing and metal prices
Source: Bloomberg, AMP Capital
Gold is likely to be a big beneficiary, to the extent that it is one of the best hedges (protection) against a falling US dollar.
US quantitative easing and the gold price
Source: Bloomberg, AMP Capital
Fourth, the combination of higher spot commodity prices and, potentially, the resumption of carry trades, could see the Australian dollar push higher. It rose substantially through QE1 and QE2.
US quantitative easing and the Australian dollar
Source: Bloomberg, AMP Capital
This is the last thing Australia needs now, particularly if bulk commodity prices remain subdued on Chinese softness. As a result, it adds more pressure for the Reserve Bank of Australia to resume rate cuts, which we expect this year. This in turn should help limit the upside our currency.
Finally, if QE3 boosts global confidence it should see some reversal of safe-haven bond buying and hence modest ongoing upward pressure in government bond yields.
About the author
Dr Shane Oliver is Head of Investment Strategy and Chief Economist, AMP Capital Investors.
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