Mark Lister: A beginner's guide to quantitative easing

The Federal Reserve building in Washington, D.C. Photo / Thinkstock

Opinion

The US Federal Reserve recently announced a second round of quantitative easing (QE), nicknamed "QE 2". QE is an unconventional, some would say last resort, form of monetary policy.

A central bank's primary and mainstream monetary policy tool is to raise and lower interest rates. Lowering interest rates usually encourages people to borrow as the cost of borrowing falls, therefore stimulating investment, economic activity, asset prices and spending.

QE goes a step further. With QE, the central bank firstly creates money and then uses it to buy bonds and other securities off banks and institutions.

By pumping cash directly into the financial system like this the bank hopes to both lower longer-term interest rates - its buying pressure pushes down bond yields - and also encourage banks, which after having sold assets to the central bank are now flush with more cash, to increase their lending.

The Bank of Japan, in the early 2000s, and more recently the Bank of England and the Federal Reserve, have all resorted to QE.

The first question most people would ask with regard to QE is where all of this money comes from. And yes, you read it correctly in the paragraph above - the Fed creates the money it uses to buy the assets. It essentially prints cash. But rather than use the printing press, it is all done electronically.

The Fed puts this newly created money on its balance sheet and then uses it to buy assets. Since late 2008, the Fed has created US$1.7 trillion under QE, with another US$600 billion to come under QE 2. Its balance sheet has expanded from US$900 billion of assets in August 2008 to US$2.3 trillion today.

The scale of QE is significant. The assets on the Fed's balance sheet now equate to 16 per cent of US GDP. Before QE, the ratio hovered around 6 per cent of GDP.

In the past, the Fed has used its newly minted cash to buy mortgage-backed securities, but more recently has focused on buying US government bonds, known as Treasuries. It now owns about 13 per cent of all Treasuries on issue.

It has focused on buying bonds in the 3- to 10-year range in an attempt to keep bond yields low and, therefore, encourage investment, lending and to support house and equity prices.

The Fed is trying to generate inflation, pull the US dollar down and help stimulate economic growth. At 1.1 per cent, inflation is too low for the Fed's liking, and growth of 2 per cent is not high enough to generate jobs and bring down America's 9.6 per cent unemployment rate.

A lower greenback helps make US exports more competitive. The Fed regards deflation as a bigger risk than inflation and has stated it will "do whatever it takes" to avoid deflation. An environment of falling prices would be catastrophic for the US, given its high level of debt.

Inflation makes debt smaller (in real terms), but deflation makes it bigger.

One of the Federal Open Market Committee governors keeps voting against QE, which highlights conflicting opinions over whether it will ultimately succeed or not.

Thomas Hoenig, the member from Kansas, has voted against lowering interest rates and QE at seven consecutive meetings. One more dissent and he will match the record of eight dissents recorded by any board member way back in 1980.

Hoenig is opposed to QE because he believes it will lead to high inflation in future.

Hoenig may well be correct. The impact of ongoing loose monetary policy, high levels of stimulus and strategies such as QE may manifest themselves as high inflation over the medium term. You can argue both sides and there is a high level of uncertainty because QE has never been seen on this scale before.

So far, QE has not led to inflation in the US. The inflation rate is barely over 1 per cent. Inflation tends to rise when credit growth is greater than economic growth. At present, although the Fed has created a massive amount of money, much of this still sits on bank balance sheets. Lending growth has been anaemic.

We have seen the same pattern in New Zealand. Households and businesses are already highly indebted. They simply don't want more debt and, in fact, are trying to repay it, or "deleveraging".

But Hoenig has a point. You would think that printing more of anything debases its value. QE does not need to lead to inflation, as long as the Fed acts quickly to withdraw this stimulus once the economy starts to recover.

That's a big if. There is a real risk the Fed could wait too long and inflation spikes as a result. To avoid inflation when the economy recovers, the Fed will need to promptly start selling the bonds it bought. It will then need to destroy the cash it created (presumably with a few more computer keystrokes).

Some would go a step further and argue that the Fed is even risking an environment of hyper-inflation. Three historical examples of hyper-inflation have been Zimbabwe from 2000-2009, Argentina in the 1970s and Germany in the 1920s. All suffered inflation rates of well over 1000 per cent and the cause has been put down to governments printing money.

This sounds a lot like what the United States is doing now. There is, however, a very important distinction between what the Fed is doing and the money printing seen in these historical examples. The Fed is printing money as part of its monetary policy.

In the case of Germany, Argentina and Zimbabwe, those governments printed money as part of fiscal policy and used the cash to pay the bills.

Printing money to fund or "monetise" a government's debt debases the currency and leads to hyper-inflation.

Some will argue that the Fed is effectively funding the government deficit because it is buying government bonds. However, this is not the case, because the Fed is buying bonds in the secondary market and the proceeds flow to the private sector, not the government.

Only if the Fed is slow (either by mistake or design) to remove its stimulus when the economy recovers can those who accuse it of monetising the US budget deficit have some conclusive evidence to support their view.

Another area of the financial system where QE is having a significant impact has been on currency markets. Some argue that the US dollar has fallen because investors are concerned that QE is debasing the US currency, making it worth less relative to other currencies.

This sounds plausible, but loses some credence when you consider that the current inflation rate in the United States is just 1.1 per cent.

The key drivers of the US dollar's weakness are probably interest rate differentials and relative growth outlooks, and not inflation concerns.

Currencies like the New Zealand and Australian dollars offer much higher interest rates and have a better GDP growth outlook than the United States at present, which could lead to even higher interest rates relative to the United States.

Eventually, this money-printing exercise should fire up the US economy. Indeed, recent economic data has been slightly more promising.

However, no central bank can drive economic growth by itself. Monetary policy is only one element of economic management.

The government must also pull its weight by ensuring micro- and macro-policy settings, tax regimes and spending are all conducive to generating effective deployment of resources and growth in productivity.

America remains the world's pre-eminent economy, as the Economist recently put it. The US is the king of innovation, "where the world's best universities meet the world's deepest pockets". In time, it should be able to draw on its competitive advantages and stage an economic recovery.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column should not be regarded as specific investment advice.