Quantitative Easing (QE) are the latest buzz words in the financial
markets. It is important to become intimately comfortable with these
words because they will be the catch phrase of 2009 thanks to the latest
interest rate cuts by the Federal Reserve and the Bank of Japan.
What is Quantitative Easing?
Quantitative
Easing is a monetary policy tool that central banks use when they run
out of room to cut interest rates. The word "Quantitative" refers to the
money supply and easing money supply means to increase it. For many
people, this term is new and with good reason because it was only coined
by the Bank of Japan in 2001 after they took interest rates to zero.
When that happened, they obviously had no more room to cut rates, which
made Quantitative Easing their Plan B.
Quantitative Easing
basically involves printing money to buy a variety of securities with
the end goal of flooding the financial markets with cash or liquidity.
By doing so, it increases the amount of currency in circulation which
reduces the value of the currency and boosts inflation.
A good way
to look at this is if there were only 100 signed Babe Ruth baseball
cards worth $1000 each in the world and all of a sudden another 1000
signed baseball cards were discovered, then you would expect each
baseball card to now be worth a lot less. Having more baseball cards in
the market at lower prices hopefully spurs more activity in the baseball
card market. In many ways, the goal of Quantitative Easing is the same.
By
the flooding the market with liquidity, the central bank aims to
promote lending and prevent a shortage in the future. Of course
Quantitative Easing is much more involved than baseball card trading.
What Outcome Can Be Expected from Quantitative Easing?
Granted
that Quantitative Easing has only ever been implemented once in Japan,
there is not much precedent. However with that in mind, we are sure that
the Fed analyzed the outcome of Japan's zero interest rate policy
before bringing US interest rates within a whisker of Japan's 2000
levels.
The Bank of Japan embarked upon this new concept in
monetary economics in its effort to fight a frustrating period of
economic stagnation and decline in 2001 which lasted until 2006. With
rates at 0% the central bank was forced to implement some new level of
policy to fight the wave of deflation that had plagued the country.
Deflation, another renewed catch-word in today's economic climate, is an
overall decline in prices over an extended period of time.
We are
all familiar with how disastrous an inflationary state can be on an
economy, unfortunately deflation is no different. The cause of the
phenomenon is when consumers become so resistant to spending that
sellers are forced to continuously cut prices. In Japan, the BoJ
accomplished their easing targets by expanding the limits as to the
types of securities that they would purchase; for instance buying
long-term treasuries, asset-backed securities, equities, and new levels
of commercial paper.
This is all in an effort to flood the
financial system with so much excess reserves and liquidity that they
would be forced to resume normal lending situations.
In the first
year of Quantitative Easing, USD/JPY rose 18.5 percent. This means that
the Japanese Yen weakened against the US dollar, which is a textbook
reaction to Quantitative Easing. The Nikkei also dropped 28 percent.
Between
2002 and the end of 2004, USD/JPY fell 22 percent as the Japanese
economy began to stabilize. During that same time the Nikkei recovered
20 percent, but not before it fell another 20 percent. Although it has
been heavily debated whether Quantitative Easing drove the turnaround in
the economy, most people agree that it put a halt to deflation.
Fed's Version of Quantitative Easing
With
US interest rates pretty much at zero, the Federal Reserve has
informally adopted its own version of Quantitative Easing. Some people
may even argue that the Fed has been pursuing this strategy for months
now. In conjunction with the Treasury department, the Fed has doubled
their balance sheet in the past 3 months to more than $2 trillion.
They
have done this by purchasing direct equity investments in banks, easing
standards on commercial paper purchases, made efforts to relieve
institutions of their toxic asset-backed securities and is now
considering buying Treasury bonds and agency debt.
By buying these
assets, they are adding money into the financial system. Like the Yen,
Quantitative Easing exposes the US dollar to significant downside risks,
but it is also the step that the central bank needs to take to
stabilize the US economy and to prevent a deflationary spiral.
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