Monday, 15 April 2013

Monetary Easing - How will it all end?

The first round of quantitative easing was implemented by Japan back in the early 2000s as they embarked on ending years of deflation.  With interest rates at near zero they aimed to provide excess liquidity to banks in order to promote private lending and spur consumers to spend rather than save.  The bulk of the operation was involved in purchasing government debt in order to increase its targeted current account balance.  This policy was lifted 5 years later and there was little evidence to suggest much of an effect.  The excess liquidity had provided little impact as both borrowing rates and JGB yields were close to zero making the net effect minimal.

A few years passed before QE reared its head again, and this time in a much greater scale.  The financial crisis in 2008 saw central banks around the world embark on trying to rescue the global economy from recession.  The United States, Europe and UK commenced QE after interest rates were dropped to near zero.  Both the UK and US used a similar method of QE, buying government debt and mortgage backed securities to stimulate growth.  Europe used a slightly different approach, whereby they used a repurchase agreement via their Long Term Refinancing Operations (LTRO).  The ECB bought government debt mainly off banking institutions with the intention for these to be repurchased at a later date.  This enabled banks to have more liquid cash on their balance sheets to help during the financial crisis.  Being relatively successful, the first round of LTRO repayments have been made and more which is an encouraging sign banks have stabilized and resurrected their toxic balance sheets.
The UK has done £375bn worth of QE since 2008 and with the economy still in a fragile state this could be increased.  The US has done over $2.3tn worth so far and as they continue with monthly purchases of $85bn the total figure will be approaching almost $4tn globally towards the end of this year.
Japan’s new Prime Minister, Shinzo Abe, has vowed to get their economy back on track once more and combined with the new governor Haruhiko Kuroda they have established an extremely aggressive monetary easing policy which has flooded the economy once more with liquidity.  However this time it is different, previously it has been focused just on monetary easing through quantitative easing.  Now Abe is combining fiscal and monetary policy to achieve targets.  His three arrow strategy is as follows:
  1. Monetary Easing - They have committed to $75bn worth of QE per month in order to achieve inflation target of 2% and GDP growth of 2%.
  2. Deficit financed budget filled with public sector and infrastructure spending
  3. Structural reforms to achieve growth through sthe timulating private sector.
As mentioned Japan was the first economy to undertake quantitative easing, however this new more aggressive approach combining structural and fiscal reform may just be what it takes to have a significant impact.

So does QE work?

Well central bankers would argue yes, it's achieved a lower borrowing rate, provided liquidity to banking institutions and supported businesses through this.  However, whilst it may have stopped the economy from being in a worse situation five years ago, the long term effects may be very detrimental.

What has happened?

Aggressive monetary easing has acted as a ballast to most asset classes.  As they are mainly purchasing government debt, it has driven prices to record highs, and yields to the floor.  Equity markets are another one that has benefited from this support as borrowing costs are maintained at a low level providing easing debt financing.   Gold is another one that has benefited as an inflation hedge, many would argue QE leads to inflation over the long term (see below). 

So what happens next?  

Many would argue, pumping all this money into the system will lead to inflation as the money supply has increased.  More money in the system means the value of the currency goes down and prices rise.  However, this is not the case, since 2008 we saw a slight rise in global inflation however it has now returned to fairly subdued levels with little sign of moving.  The reason why this money may not lead to inflation is down to the implementation of QE.  Governments have been purchasing debt which is predominately owned by banks, pension funds and insurance companies for purposes of liability matching.  As such these are all end game holders, whereby they would hold the debt to maturity.  When the government buys the bonds off these investors, the cash will be maintained and used to purchase another type of liability matching security, namely bonds.  The end result is the velocity of money remains very low and does not filter down through the economy being spent by various parties.  What has actually been happening is the vast monetary easing has slowly been depreciating the developed nation currencies and like Japan recently been exporting low prices around the world, bringing with it deflationary pressures. 

In past experiences, deflation has been present during times of QE, Japan has experienced this for over a decade and has not provided enough of a push to shift this trend.

As the US economy picks up, I am concerned with the detrimental impact to all asset classes when QE stops.  A number of FED committee members have expressed their hawkish (higher interest rates) views, and this is a cause for concern.  They do not want to continue with $85bn a month any longer than is necessary and this could essentially pull the rug from underneath everyone’s foot sending bonds especially spiralling from record high's.

A few words of caution here, but it is evident things are coming to a head, and I expect the end of this year will present some interesting opportunities for global markets.


  1. Q ... uite,
    E ... xciting!



  2. Great I understood what are potential happen next after monetary consider.

  3. I have been re-watching the documentary “. They state that the 3 depressions we had in America between 1920 and 1938, including the Great Depression, were caused by The Federal Reserve when they reduced the money supply. They did it over a period of years before the actual crash. I don’t fully understand how the Federal Reserve increases and decreases the money supply but I wonder what the Fed’s current policy of Quantative Easing (QE2) will do in the near future. Is it reducing the supply or increasing it? Have agood daya...........