Quantitative easing is a powerful monetary policy tool to revive markets and the economy. However, recent analysis has shown that there is no difference on how it affects economy. If at all, central banks’ policies has made markets more volatile than before with Warren Buffet stating that if QE is halted it will be the “shot heard around the world”
Yesterday, the Dow Jones Industrial Average fell from the peak of 15,535 to close at 15,307. S&P 500 too corrected sharply to 1,655 from the peak of 1,687. However, the worst hits were Asian markets today. The Japanese Nikkei 225 Index plummeted more than 7%, down almost 10% from the top while the BSE Sensex was down nearly 2%. Hong Kong’s Hang Seng was down over 2% as well. European markets are trading sharply lower, down between 2%-3%. This comes on the heels of a big hit that commodities like gold, silver and copper have taken in April as the dollar rallied against all calculations. What is roiling the global markets?
The worry is that the US Federal Reserve could “taper off” its quantitative easing program (QE) or simply wind it down in a phased manner, though the decision would be taken in June, when the Federal Reserve holds its Federal Open Markets Committee meet (FOMC). In other words, the American central bank is slowing down its stimulus program to revive America’s economy. This has spooked the markets. The assumption that the liquidity that is coursing through the global markets will shrivel and risk assets will have no takers. Warren Buffet has even remarked that if the stimulus program to revive America’s economy stops it will be the “shot heard around the world”.
QE has become a hotly debatable subject in both the academic quarters as well as among top investors and analysts in Wall Street (and the world over as well). Ben Bernanke, the Federal Reserve chairman, praised QE as an effective tool for fighting recession. In his prepared speech before the Senate’s Joint Economic Committee he said yesterday that, “Over the nearly four years since the recovery began, the economy has been held back by a number of headwinds. Some of these headwinds have begun to dissipate recently, in part because of the Federal Reserve's highly accommodative monetary policy (QE).” Furthermore, he warned that if the QE was to stop, it would lead to repercussions. He said, “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”
However, during the question & answer session after that speech he sang a different tune. In reply to a question he suddenly said that the Federal Reserve would be prepared to cut back on QE. He said, “We will in steps respond to that (the ‘improved’ economic strength) by reducing the amount of accommodation in a way that’s appropriate.” And this could be within months. The moment he said, this, US stocks started falling like a stone.
Ben Bernanke has cited that higher stock market prices are a reflection of the successes of the QE program, which was initiated in 2008 after Lehman Brothers went kaput. Indeed, the market has reacted positively each time the QE program was launched. There has been three QEs and an “Operation Twist” programs since, each of which propelled the S&P to newer highs. Last night S&P reached a record high of 1687. Yet, the US labour market continues to remain weak (i.e. high unemployment) and inflationary expectations remain subdued still.
For the uninitiated, the “quantitative easing”, or popularly known as QE, is nothing but buying bonds by the US Federal Reserve from the banks to create liquidity for them, which in turn will be used to help businesses and entrepreneurs, and which in turn will help the United States economic revival. However, it is assumed most of money has gone to support stocks and commodities and when this is stopped markets will suffer withdrawal symptoms. Thus the “tapering off” in question means less printing money and less supply to the economy which is in need of cash for revival.
There are mixed views on the effects of QE on world markets. Some top investors feel that the QE has nothing to do with the economic recovery. Bill Gross of PIMCO feels that corporate fundamentals were the key to recovery and not QE (even though QE may have helped ‘indirectly’). In a newsletter to the clients, he said, “Based on our analysis, QE has not been the driving force behind rising equity prices in recent years. We found that since 2009, corporate profits have had a more direct relationship to stock prices.” He advises investors to look at corporate profits instead of worrying too much about the impact of QE.
An incisive analysis of QE comes from Mark Dow, who writes a blog
. According to Dow, there is absolutely no difference in printing dollars and money supply. In other words, the effect of QE has little or no bearing on the economy as a whole and is simply a placebo effect. Typically, QE should increase money supply and lead to higher inflation. However, Dow had found out that credit reserves held by banks with the Federal Reserve actually decreased between 1981 and 2006! He says, “From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.”
According to Dow, financial deregulations and innovation over the years significantly changed the way at which the monetary policy mechanism worked. Increased collateral lending and securitisation meant different numbers on the books and determined the real extent of supply, not the reserves held by banks with Federal Reserve. In other words, banks decide the amount of money supply and not the Federal Reserve. The latter simply decides the extent of liquidity while it is up to the former to decide whether to lend capital or not. More interestingly, Dow also found that printing money had little or no effect on inflation. A graph below shows how scattered the data is, implying no relationship between money supply and CPI (inflation).
If this is the case, why is the Fed doing this QE? According to Dow, it is more of a psychological than fundamental. The Federal Reserve is simply providing ‘comfort’ to investors by keeping rates low enough for investors to borrow (and refinance) to put money back into the economy vis-à-vis new businesses, consumerism, etc. So ingrained is the psychological effects of QE on investors worldwide, particularly American investors, that talks of “tapering off” has already spooked the markets. Investors have become too used to the notion of “easy money”, especially with S&P is scaling new highs, for four long years, and investors are clamouring for more.
Because the Federal Reserve, and central banks world over, have created conditions such that investors have no place to put money elsewhere but back into the markets, since fixed income yields too little,. Therefore, money has to go somewhere else—into the markets—and therefore made the global economy far more volatile, dangerous and artificial.
Some intellectuals feel that QE stimulus has helped the American economy while others think that once stopped, it is a disaster waiting to happen. Ultimately, it may all be psychological and behavioural. Unless the Fed comes in and assures investors that QE will continue, markets may continue to fall. May be that is what the Fed wanted after all. All global markets had become too frothy and all Bernanke probably wanted to do is to cool them a bit!