The US Federal Reserve has started aggressive monetisation, dubbed “quantitative easing” (QE), since the collapse of Lehman Brothers and AIG in mid-September 2008. This is evidenced by the fact that the Fed’s balance sheet, as measured by the ratio of the monetary base plus excess reserve to GDP, has soared from $900 billion (or 6% of GDP, which is about typical) to over $2.3 trillion (or 16% of GDP) since then.
Reflecting this massive liquidity injection is the effective Federal funds rate (0.125% at the time of writing), which has been below the policy target rate since mid-September (Chart 1). This is an upshot of the Fed oversupplying the banks with reserves by buying US Treasuries and other assets. Through QE, the Fed seeks to target the level of liquidity (or bank reserves at the central bank), not interest rates.
The Fed implements QE in several ways, including various term auction facilities, ad hoc credit lines to specific institutions and direct purchases of commercial papers, government agency debt and asset-back securities. The last move is meant to by-pass the banking system, and lend directly to the corporate and housing sectors when the banking sector is unwilling to do so. If these fail to revive the credit system, more unconventional measures, including direct buying by the Fed of long-term US Treasuries, can be expected.
In theory the Fed is printing money; but in practice it is not. Bank reserves at the Fed are part of the base money, or high-power money. Through bank lending an increase in the base money will lead to a more than proportionate increase in the broad money supply, such as M2. The ratio of M2 to base money is known as the “money multiplier”, and it relies on banks extending loans to take effect.
However, the problem today (just like in Japan in the 1990s) is that the bank intermediation process has been broken. US banks have scaled back lending sharply by tightening lending standards (Chart 2) and have just sat on their pile of reserves at the Fed. Hence, the money multiplier has collapsed (Chart 3) due to the banks’ risk averse behaviour following the subprime crisis. With the money multiplier malfunctioning, the Fed QE has served to create liquidity in the form of bank reserves, but not yet in the form of money printing.
The US is stuck in a “liquidity trap”, where the banks are flooded with liquidity and the effective funding cost has fallen towards zero, but they are still not willing to lend. The logical solution to this is to boost fiscal spending, i.e. let the government’s visible hand pull the economy out of the financial quagmire. Another way is for the Fed to by-pass the banking system to lend to the corporates directly.
The huge amount of liquidity pumped into the system via QE will not ignite inflation in the short-term (the next couple of years). This is because the current liquidity demand is not motivated by the desire to spend, but to avoid investment losses and repair confidence in the financial system. This is clearly seen in the sharp decline in money velocity (nominal income divided by M2, Chart 4), which is a reflection of the collapse of the money multiplier. In other words, QE under the current situation only serves to limit the deflationary impact in the coming years, as the economy works its way through a post-bubble debt liquidation adjustment.
In the longer-term, the inflationary impact of QE will depend on how fast the Fed withdraws the liquidity when the money multiplier is normalised. It is not difficult for the Fed to retreat its monetary stimulus through open market operations and sell back the short- and long-term Treasuries and other securities that it has bought.
A policy mistake on re-igniting inflation cannot be ruled out, if the Fed is too slow to reverse QE. But given the expected long and painful de-leveraging process that the US economy is going through, QE today does not necessarily point to higher inflation later. Indeed, Japan still has not shaken off the deflationary drag today, despite five years of QE by the Bank of Japan (BoJ).
Impact on the dollar
By increasing the supply of the currency, QE does not have to hurt the exchange rate because there are other factors at work too. For example, the BoJ implemented QE between March 2001 and March 2006, but the JPY/USD exchange rate fell in 2001 only, and then strengthened from 2002 through 2004 when the US Fed cut rates aggressively after the bursting of the IT bubble.
The point is that the impact of QE on the exchange rate (in this case the US dollar) also depends on what other central banks do. Amid the current economic backdrop, other major central banks, notably the European Central Bank (ECB) and the Bank of England (BoE), are likely to follow the US Fed’s QE path. The European and the UK banking systems are just as badly hurt by the subprime woes as the US system and their money multipliers are at least as badly damaged. The breakdown of financial intermediation will eventually force the ECB and BoE down the QE path and to act as financial intermediaries on behalf of the private sector.
Further, unless the market expects QE to cause runaway inflation in the US (which is not my base case), the dollar will not collapse. So, with no inflation scare and if the US Fed, ECB and the BoE all adopt QE, there will be no net negative impact on the dollar. As long as risk aversion remains high, the dollar will remain strong against the major currencies. Over the medium-term, however, the dollar should weaken, especially against the Asian currencies, as part of the global adjustment process.
The bottom lines
The Fed’s QE is just plugging the financial black-hole caused by the subprime crisis. Financial intermediation is broken, money velocity is falling and the money multiplier is impaired. Inflation will not arise under these circumstances. As long as risk aversion remains high, QE will be more positive for US Treasuries than for equities, which will have to climb a wall of worries about earnings growth under debt-deflation in the short-term.
However, the US Treasury market is another bubble waiting to go bust when risk aversion fades. There will be gigantic amount of bonds coming to the market due to the US government bailouts. The current sub-3% long Treasury yield is unsustainable when risk taking behaviour becomes normalised. Finally, the dollar will not weaken under risk aversion as other major central banks will be forced down the road of QE in the coming months, though it should be a weak currency in the medium-term.
Chi Lo is a research director at Ping An of China Asset Management (HK).
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