Enter QE2, followed by dollar drama and hope

[mr funny]

http://www.businesstimes.com.sg/sub/...11391,00.html?

Published November 3, 2010

Enter QE2, followed by dollar drama and hope

Some expect US$ to fall 20% over next few years; others hope for economic pick-up

By ANDREW MARKS
NEW YORK CORRESPONDENT


AT approximately 2pm today in the US, the Federal Reserve will unveil QE2 for all to see - but the Fed's money creation machine has already sent jitters across the world.

Bill Gross, manager of the world's largest mutual fund, warned yesterday that this latest round of asset purchases by the Fed to stimulate the economy will produce a massive plunge in the already weakened US dollar.

'The dollar is in danger of losing 20 per cent of its value over the next few years if the Federal Reserve continues unconventional monetary easing,' the famed money manager at Pacific Investment Management Co (Pimco) told Reuters.

The first round of this strategy saw the Fed mopping up US$500 billion of government bonds. In the second round of quantitative easing - QE2 - its planned purchases are estimated to range from a mere US$100 billion to a whopping US$1.5 trillion.

'QE2 not only produces more dollars but it also lowers the yield that investors earn on them and makes foreigners less willing to hold dollars in current form or at current prices,' said Mr Gross.

On the other side of the Pacific on Monday, China's Commerce Ministry also seemed to be expecting a 'shock and awe' programme from the Fed, declaring that the Fed's unconventional monetary easing would produce a currency war.

'The continued and drastic US dollar depreciation recently has led countries including Japan, South Korea and Thailand to intervene in the currency market, intensifying a currency war. In the midterm, the US dollar will continue to weaken, and gaming between major currencies will escalate,' it said.

'The dollar isn't the target of Fed policy; the economy is,' said Joel Naroff, president and chief economist at Naroff Economic Advisors. 'If the Fed has to make a weaker dollar while pumping up the economy, so be it. It makes US goods more competitive overseas.'

Which is, of course, what has got China and other big net exporting countries hot under the collar - and currency analysts talking war. 'I think the US government's position that China is artificially keeping the yuan low is the ultimate root of the currency problem, and it's time to bring this issue to a head,' said Nick Colas, chief market strategist at BNY ConvergEx.

The impact is expected to touch every segment of the economy and the markets. Even so, by Credit Suisse's math, a US$500 billion purchase would add just 45 points, or less than 4 per cent, to the S&P 500. Much of this has already been priced into the market.

'It will largely be a non-event when they announce it because QE2 is already in the market,' said Hugh Johnson, president of Hugh Johnson Advisors, who remains bullish on stocks. 'From here, stocks will be on hold until we see QE2 show up in the economic numbers and in earnings. We'll have a good idea of the impact at the end of the year.'

Most economists dismissed the inflation fears that the bond market has expressed in the last two weeks, asking: if, two years from now, inflation is 2 per cent higher, is that bad?

The answer is no, said Mr Naroff. 'I'd rather be looking at 2.5 per cent inflation and a booming economy than a 1-1.5 per cent inflation rate and anaemic growth that doesn't produce enough jobs, and so eventually will the stock market,' he said.

In recent days, Fed officials have hinted that QE2 could be far less than the US$500 billion to US$1 trillion the stock market and currency markets have been pricing in, and many investors have begun paring back those aggressive expectations.

'The dollar's slide since September has been pricing in aggressive price action by the Fed to around US$1 trillion,' said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange.

'Price action on the dollar the last few days means currency traders are trimming those short dollar bets,' he said.

In theory, the asset purchases are expected to put more money into the system, reflate assets and help drive down lending rates.

'Will we see stronger economic activity as a result of QE2? Maybe,' said Mr Harris. 'It will be export-dependent in the short run because lowering long- term rates another half of a per cent is not going to change the way corporations are spending or hiring. It just makes it easier for companies to sit back, issue more bonds, and pocket the difference.'

As to the Fed's focus on avoiding the kind of deflation that has wracked Japan's economy over the past 20 years, David Rosenberg, chief economist and strategist at Gluskin Sheff, fears that, instead, the Fed may trigger an asset bubble, 'kicking the stock market into a liquid sugar- high'.

Assuming a middle- ground approach of US$500 billion over the next several months, Mr Naroff doubts QE2 will push long-term rates down by more than 25-30 basis points.

'Fifty bps is what you really need to generate a lot of activity from businesses and banks. In the end, QE2 will amount to a tax cut for people capable of refinancing. It will give many people the financial wherewithal to spend more in six months,' said Mr Naroff, who believes QE2 will indirectly contribute to the 4-5 per cent GDP growth rate he is forecasting for the second half of 2011.

[vboy]

Quantitative easing (QE) is a monetary policy used by some central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.
A central bank implements quantitative easing by first crediting its own account with money it creates ex nihilo ("out of nothing").[1] It then purchases financial assets, including government bonds, agency debt, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus hopefully induce a stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.
Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to sit on the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.[1]
"Quantitative" refers to the fact that a specific quantity of money is being created; "easing" refers to reducing the pressure on banks.[2] However, another explanation is that the name comes from the Japanese-language expression for "stimulatory monetary policy", which uses the term "easing".[3] Quantitative easing is sometimes colloquially described as "printing money" although in reality the money is simply shifted from member bank dollar deposits to financial instruments.[4] Examples of economies where this policy has been used include Japan during the early 2000s, and the United States, the United Kingdom and the Eurozone during the global financial crisis of 2008–the present, since the programme is suitable for economies where the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

Concept
Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements, to indirectly influence the supply of money.[1] In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain the level of money supply desired by the central bank, and so quantitative easing is employed to further boost the amount of money in the financial system.[1] This is often considered a "last resort" to increase the money supply.[5][6] The first step is for the bank to "borrow" from the member bank reserve accounts, creating a depository liability.[7] It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds,[1] in a process known as "monetising the debt". The net impact on the central bank balance sheet is zero.
For example, in introducing its QE programme, the Bank of England bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies.[8] The banks, insurance companies and pension funds can then use the money they have received for lending or even to buy back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency.[citation needed] These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital.[9] Another side effect is that investors will switch to other investments, such as shares, boosting their price and thus creating the illusion of increasing wealth in the economy.[8] QE can reduce interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying and financially weaker bodies.
More specifically, the lending undertaken by commercial banks is subject to fractional-reserve banking: they are subject to a regulatory reserve requirement, which requires them to keep a percentage of deposits in "reserve",[citation needed]: these can only be used to settle transactions between them and the central bank.[9] The remainder, called "excess reserves", can (but does not have to be) be used as a basis for lending. When, under QE, a central bank buys from an institution, the institution's bank account is credited directly and their bank gains reserves.[8] The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of "thin air" by increasing debt (lending) through a process known as deposit multiplication and thus increase the country's money supply. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet Modern Money Mechanics explains the process.
A state must be in control of its own currency and monetary policy if it is to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on the European Central Bank (ECB) to implement it.[citation needed] There may also be other policy considerations. For example, under Article 123 of the Treaty on the Functioning of the European Union[9] and later the Maastricht Treaty, EU member states are not allowed to finance their public deficits (debts) by simply printing the money required to fill the hole, as happened, for example, in Weimar Germany and more recently in Zimbabwe.[1] Banks using QE, such as the Bank of England, have argued that they are increasing the supply of money not to fund government debt but to prevent deflation, and will choose the financial products they buy accordingly, for example, by buying government bonds not straight from the government, but in secondary markets.[1][9]
[edit] History

Quantitative easing was used unsuccessfully[10] by the Bank of Japan (BOJ) to fight domestic deflation in the early 2000s.[11] During the global financial crisis of 2008–the present, policies announced by the US Federal Reserve under Ben Bernanke to counter the effects of the crisis are a form of quantitative easing. Its balance sheet expanded dramatically by adding new assets and new liabilities without "sterilizing" these by corresponding subtractions. In the same period the United Kingdom used quantitative easing as an additional arm of its monetary policy in order to alleviate its financial crisis.[12][13][14]
The European Central Bank has used 12-month long-term refinancing operations (a form of quantitative easing without referring to it as such) through a process of expanding the assets that banks can use as collateral that can be posted to the ECB in return for euros. This process has led to bonds being "structured for the ECB".[15] By comparison the other central banks were very restrictive in terms of the collateral they accept: the US Federal Reserve used to accept primarily treasuries (in the first half of 2009 it bought almost any relatively safe dollar-denominated securities); the Bank of England applied a large haircut.
In Japan's case, the BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[16] The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities and equities, and extended the terms of its commercial paper purchasing operation.[17]
[edit] Risks

Quantitative easing is seen as a risky strategy that could trigger higher inflation than desired or even hyperinflation if it is improperly used, and too much money is created. It can fail if banks are still reluctant to lend money to small business and households in order to spur demands. Quantitative easing can effectively ease the process of deleveraging as it puts pressure on yields. But in the context of a global market, home printed money can flood abroad and spark asset bubles in developing economies.
Quantitative easing runs the risk of going too far.

The neutrality of the style of writing in this article is questioned. Please see the discussion on the talk page. (October 2010)
An increase in money supply to a system has an inflationary effect by diluting the value of a unit of currency. People who have saved money will find it is devalued by inflation; this combined with the associated low interest rates will put people who rely on their savings in difficulty.

The neutrality of the style of writing in this article is questioned. Please see the discussion on the talk page. (October 2010)
If devaluation of a currency is seen externally to the country it can affect the international credit rating of the country which in turn can lower the likelihood of foreign investment. Like old-fashioned money printing, Zimbabwe suffered an extreme case of a process that has the same risks as quantitative easing, printing money, making its currency virtually worthless.[1]
On the other hand, in economies when the monetary demand is highly unelastic with respect to interest rates, rates close to zero, or a depressed money market (symptoms which imply a liquidity trap), QE can be implemented in order to further boost monetary supply, and assuming that the economy is well below potential (inside the production posiblities frontier), the inflationary effect would not be present at all, or in a much smaller proportion.
[edit] Origin

The original Japanese expression for "quantitative easing" (量的金融緩和, ryōteki kin'yū kanwa), was used for the first time by a Central Bank in the Bank of Japan’s publications. The Bank of Japan has claimed that the central bank adopted a policy with this name on 19 March 2001.[18] However, the Bank of Japan's official monetary policy announcement of this date does not make any use of this expression (or any phrase using "quantitative") in either the Japanese original statement or its English translation.[19] Indeed, the Bank of Japan had for years, and in an article published in February 2001 had claimed that "quantitative easing … is not effective" and rejected its use for monetary policy.[20] Speeches by the Bank of Japan leadership in 2001 gradually, and ex post, hardened the subsequent official Bank of Japan stance that the policy adopted by the Bank of Japan on March 19, 2001 was in fact quantitative easing. This became the established official view, especially after Toshihiko Fukui was appointed governor in February 2003. The use by the Bank of Japan is not the origin of the term "quantitative easing" or its Japanese original (ryoteki kinyu kanwa). This expression had been used since the mid-1990s by critics of the Bank of Japan and its monetary policy.
The earliest written record of the phrase and concept of "quantitative easing" has been attributed to the economist Dr Richard Werner, Professor of International Banking at the School of Management, University of Southampton (UK). At the time working as chief economist of Jardine Fleming Securities (Asia) Ltd in Tokyo, and noted for his 1991 warning of the coming collapse of the Japanese banking system and economy (reference: Richard A. Werner, 1991, The Great Yen Illusion: Japanese foreign investment and the role of land related credit creation, Oxford Institute of Economics and Statistics Discussion Paper Series no. 129), he coined the expression in an article published on September 2, 1995 in the Nihon Keizai Shinbun (Nikkei).[21]
According to its author, he used this phrase in order to propose a new form of monetary stimulation policy by the central bank that relied neither on interest rate reductions (which Werner claimed in his Nikkei article would be ineffective) nor on the conventional monetarist policy prescription of expanding the money supply (e.g. through "printing money", expanding high powered money, expanding bank reserves or boosting deposit aggregates such as M2+CD—all of which Werner also claimed would be ineffective).[3] Instead, Werner argued, it was necessary and sufficient for an economic recovery to boost ‘credit creation’, through a number of measures.[21] He estimated at the time that the incipient bad debt problem of the Japanese system (i.e. including future bad debts) amounted to about ¥100 trillion, or 20% of annual Japanese GDP, and that this had increased banks’ risk aversion. The subsequent slowdown in bank credit extension was the major problem, because commercial banks are the main producers of the money supply, through the process of credit creation. He thus recommended as a solution policies such as direct purchases of non-performing assets from the banks by the central bank, direct lending to companies and the government by the central bank, purchases of commercial paper (CP) and other debt, as well as equity instruments from companies by the central bank, as well as stopping the issuance of government bonds to fund the public sector borrowing requirement and instead having the government borrow directly from banks through a standard loan contract.[22] All of these, Werner claimed, would stimulate credit creation and hence boost the economy. Many of these policies have recently been adopted by the US Federal Reserve under Chairman Bernanke, who was familiar with the debate on Japanese monetary policy, under the expression of "credit easing" (see below).
However, while Werner used and explained the concept of credit creation in his article, he chose not to use it in the article’s title, as too few readers would be familiar with it and alternative expressions were associated with flawed or failed policy prescriptions. Werner preferred to coin a new phrase.[3] In his subsequent writings, including his bestselling book on the Bank of Japan (Princes of the Yen, M. E. Sharpe, and his 2005 book New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, Palgrave Macmillan), Werner argues that the Bank of Japan’s usage of his expression ‘quantitative easing’ may be misunderstood. While suggesting it was adopting the policy suggested by a leading critic, the Bank of Japan implemented the standard monetarist expansion of bank reserves and high powered money, which Werner had predicted would fail.[19] It is not obvious why the Bank of Japan chose to use Mr Werner’s expression, and not the already existing and widely used expressions ‘expansion of high powered money’, ‘expansion of bank reserves’ or, simply, ‘money supply expansion’, which more accurately describe its adopted policy at the time.[23]

[mr funny]

http://www.straitstimes.com/Money/St...ry_599465.html

Nov 5, 2010

US FISCAL STIMULUS

QE2 unveiled: It's swim or sink

Fed hopes purchase of bonds worth US$600b will stimulate economy


WASHINGTON: The QE2 has set sail - but analysts are still divided, even unsure, about where this voyage will end.

If Federal Reserve chief Ben Bernanke is right, the purchase of a whopping US$600 billion worth of bonds over the next six months will drive down longer-term interest rates, given that short-term rates cannot go any lower.

This should ripple through markets, pushing down rates for housing loans and corporate bonds.

That would encourage home owners to refinance into cheaper mortgages and push businesses to make investments and create jobs.

There could also be a spin-off effect, given that the move is expected to further weaken the US dollar, in turn boosting exports down the road.

But there are doubts about whether the latest round of the policy known as quantitative easing - dubbed QE2 - will work, and whether it will do more harm than good.

It is smaller than what Fed policymakers called their 'shock and awe' approach to the 2008 financial crisis, when the Fed bought US$1.7 trillion (S$2.2 trillion) of bonds to lower long-term interest rates.

'Given the scale of the balance sheet problems facing households and financial institutions, it is simply too modest to overcome those obstacles,' said Mr Paul Ashworth, senior US economist at Capital Economics.

'Half of all mortgage borrowers don't qualify to refinance at lower rates because they don't have enough equity in their homes,' he said.

'Larger businesses are already sitting on stockpiled cash, while small businesses dependent on banks for their credit can't get loans at any cost.'

The announced pace of bond purchases was somewhat slower than Fed officials had recently been signalling, said Mr Joseph Gagnon, a former Fed economist who has strongly argued for more action, which may explain why interest rates on 30-year bonds actually rose after the Fed announcement.

Some economists were more optimistic. With the Fed buying up huge quantities of bonds, investors will be forced to riskier assets like stocks.

'The net new QE is a bit lower than some expected but will be enough, in our view, markedly to boost... growth,' said Mr Ian Shepherdson, chief US economist with High Frequency Economics.

'As stock prices rise further, business and consumer confidence will rise, too; the rebounds are already under way, just,' Mr Shepherdson continued.

Mr Manoj Pradhan, a global economist at Morgan Stanley, pointed out that bond purchase programmes lifted growth in Europe and the United States last year - and a broadly similar approach also helped end the Great Depression.

'There are no guarantees,' Mr Pradhan said, 'but the historical precedents certainly suggest it will work.'

One thing seems undeniable: The Fed's task is harder than it would have been six months ago. Stocks might rally but businesses and consumers may wonder if any new signs of recovery are another false dawn.

The Fed move also smacks a little of desperation.

American voters frustrated by the state of the union have just handed control of the House to Republicans, as well as more seats in the Senate.

Republicans are unlikely to support another stimulus package that involved more government spending.

It was this impending gridlock that might have pushed Mr Bernanke to move, said Mr Laurence Meyer, a former Fed governor.

'Bernanke has said that fiscal stimulus... is the single most powerful action the government can take for lowering the unemployment rate, when short-term rates are already at zero,' Mr Meyer said. 'He has nearly pleaded with Congress for fiscal stimulus, but he can't count on it.'

The Fed's gambit raised protests from a sole Federal Open Market Committee member, Mr Thomas Hoenig, who fears it is an overreaction that will, down the road, cause inflation to spike.

Mr Bernanke took to the pages of The Washington Post to defend the move. In an opinion piece published yesterday, he said the risk was 'overstated'.

'Low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating,' he wrote.

But there are other risks, as well. The new actions are likely to further drive down the dollar, which has already fallen about 7.5 per cent since June against the currencies of major trading partners. This will add to global currency tensions that could lead to increased trade barriers - making the big gains in stock markets now a false indicator of confidence.

Said analyst Liu Kan of Guoyuan Securities in Shanghai: 'The second phase of the Federal Reserve's so-called economic stimulus plan will force global currencies to fall again, which certainly raises the curtain on a war of world currencies.'

NEW YORK TIMES, ASSOCIATED PRESS

With additional information from The Globe and Mail and The Wall Street Journal