Speculation over the US Federal Reserve’s plan for a second injection of quantitative easing, nicely nicknamed QE2, has been a dominant theme in the markets since Fed chairman Ben Bernanke signalled in August the fact that such a move could become a reality.
When it was announced that the Fed would move ahead with it on 3 November, nobody was very surprised. But the move is nonetheless contentious and success is not guaranteed. Increasing money supply may worsen international tensions while simultaneously unleashing conflicting fears of deflation and inflation.
The Fed will purchase $600bn (£375bn) of longer-term US Treasury securities, in eight monthly instalments of $75bn, between now and the middle of 2011. Most of the buying will be in the 2.5- to 10-year maturity range. Although the ultimate goal is to boost economic growth and job creation, one of the Fed’s immediate aims is to raise US inflation above its current low levels.
Higher inflation may seem a strange and potentially risky objective for a central bank charged with delivering price stability. But Bernanke has stated explicitly that US inflation is running at rates too low relative to what the Fed judges most compatible with its mandate. While it believes inflation at “two percent or slightly less” is consistent with its interpretation of price stability, most measures of annual US inflation have been running recently at rates of only one percent or below, indicating that the economy is suffering from a high degree of spare capacity and under-utilised resources. The Fed’s hope is that QE2 will reduce longer-term yields, raise asset prices and, as demand increases, reduce the jobless rate fall while inflation increases towards two percent.
Since the newly elected US Congress – with a much stronger Republican presence – is likely to block president Obama’s initiatives, QE2 is the only way of trying to stimulate US demand. But, though widely anticipated, it still is not clear if it is either necessary or wise.
Growth in the US is anaemic, but there is no risk of double-dip recession. The much better-than-expected job figures for October (151,000 new jobs), published only days after QE2 was announced, reinforced the feeling that the Fed acted prematurely. The chances of it succeeding are middling.
Lower mortgage rates will not revive the housing market if home prices are falling and many people are suffering from negative equity. It is also unlikely that QE2 will help small businesses to obtain credit if banks remain risk-averse.
It is too early to judge if the Fed was right. But it is important to understand the dangers. A second bout of quantitative easing will unleash large capital inflows into other markets, and the weaker dollar will heighten risks of currency and trade wars. China, Brazil and Germany have criticised the US action and a number of Asian central banks said they were preparing defensive measures.
These tensions ultimately reflect global inconsistencies: too many countries, including some running big trade surpluses such as China and Germany, want to rely on export-led growth. Trade conflicts are not solely, or even primarily, the fault of the US. But the aggressive pursuit of quantitative easing inevitably heightens the risk of conflict.
In the US, QE2 will reinforce conflicting perceptions regarding the relative risks of inflation and deflation. While the Fed signalled that US inflation is now too low, its actions have reignited market fears of long-term inflation.
Yields on short-term Treasury bonds have been depressed by QE2, but yields on 30-year bonds have risen markedly.
In other major economies, the dangers are clearer. China and India fear inflation is overheating. In Japan, deflation is a key concern. In the US, the position is ambiguous. But given the US’ huge fiscal deficit, injecting quantitative easing means creating money to finance the shortfall. This is extremely dangerous in the long term and it is not surprising that various measures of US inflationary expectations have risen in recent months.
High unemployment may be the immediate problem, but the long-term inflation monster cannot be shrugged off.
Japan is also pursuing aggressive monetary policies in the face of deflation and risks of a new downturn. The Bank of Japan (BoJ) introduced a new ¥5,000bn (£37.5bn) asset-buying programme to increase liquidity in the financial system. The BoJ also cut its key interest rate to nearly zero by lowering its target overnight call rate to between zero and 0.1 percent, from the previous level of 0.1 percent. This small reduction is psychologically important.
But in the UK, following the publication of much stronger-than-expected GDP figures for the third quarter of 2010, the Bank of England has refrained from introducing its own version of QE2, even though there is a strong case for increasing quantitative easing in the UK. Unlike in the US, where fiscal policy is lax, the British government is embarking on a forceful deficit-cutting programme and additional QE could well help to reduce risks of another downturn.
Given these uncertainties, official interest rates will remain on hold for the time being in the major economies.
European Central Bank rates may start going up a little earlier – in Q2 2011. In the eurozone, the sense of crisis has diminished. But the gap between the strong ‘core’ led by Germany, and the weak periphery economies, remains a long-term threat to the euro’s survival as a successful single currency.