'QE2 has good prospects of succeeding'

Over the past week, there have been many questions about the Fed’s new large-scale asset purchase programme (LSAP), or QE2. Below, Deutsche Bank Research lists three questions about QE2, and offers two or three perspectives on each. Peter Hooper writes from a US perspective, Thomas Mayer takes a European view and Michael Spencer an Asian (emerging market or sometimes Japanese) perspective.

What is the purpose of QE2?
Hooper: The Fed’s stated purpose is to support the economic recovery and return inflation toward its mandate-consistent level. The Fed has no illusions that QE2 will get the economy back on a strong recovery path by itself. But it does see QE2 helping the process, or at least preventing a double-dip or deflation.

Mayer: Economic fundamentals such as growth or unemployment are similar in the US and euro area. But the ECB (European Central Bank) is debating when to exit from non-standard monetary policy measures while the Fed has extended them. So there is a fundamental difference in the approach from the two central banks. Most observers argue that the difference lies in the mandate: Price stability and high employment for the Fed, only price stability for ECB. But the difference in mandate reflects deeper differences in the economic policy set-up. As Raghuram Rajan, a professor at the University of Chicago and former IMF chief economist has argued, in contrast to Europe, the US welfare system is not fit to deal with longer periods of unemployment that may arise during times of structural economic change. Hence, the onus is on the Fed to fight unemployment even if monetary policy is not the best tool.

Will it achieve this purpose, and if so, how will it work, what is the transmission mechanism and how will it affect financial markets and the economy?
Hooper: As set out in last week’s GEP, QE2 has good prospects for succeeding. It will work via purchases of longer-term assets, driving real longer-term Treasury yields lower and so causing asset values to rise, the dollar to depreciate, and inflation expectations to rise.

QE2 is viewed as a different animal from the BOJ’s version, which aimed at increasing the quantity of reserves in the banking system and so increasing the growth of bank credit to support the expansion. The Fed still has scope (indeed, a good deal more than the BOJ did) to drive longer-term rates lower and asset prices higher; it sees reserve expansion as a bi-product of its effort to do so, rather than its primary objective.

QE2 has already succeeded in reducing real longer-term yields by more than 50 bps, raised equity prices by around 10 per cent , pushed the dollar down by nearly five per cent, and raised longer-term inflation expectations by 50 bps. It has also raised the level of oil prices by around $10 per barrel. Real GDP and inflation will respond positively over time to these changes as private spending that is sensitive to interest rates and wealth is boosted, as net exports rise and as domestic prices are raised by the lower dollar, higher oil prices and increased inflation expectations.

Simulations using the Fed’s model suggest that the financial market impact to date will raise real GDP growth and inflation by ½% or more over the next two years.

Mayer: I wish to emphasise the continued rise in the flow of credit (from banks and capital markets) to the private non-financial sector, and the resulting rise in our credit impulse measure. The latter improved further in the third quarter and is fully consistent with the observed rise in domestic demand growth. Against that background, it seems to me that QE is likely to be most effective when it lowers the value of the US dollar and raises net exports. But this is exactly what the US’ trading partner countries expect and fear. Also, as I think the output gap is smaller and trend growth lower than the Fed thinks — a view my good friend Peter does not entirely share — I worry that QE will lay the seeds for higher inflation in the future.

Spencer: I’m not so sure that there’s such a big difference between the BoJ’s QE and the Fed’s. BoJ targeted banks’ reserves (its liabilities) because it wanted to encourage lending in a bank-dominated financial system. But it did so by buying asset-backed securities and government bonds. The Fed is targeting the asset side of its balance sheet to lower risk premia in securities markets in a more capital market-intermediated financial system. It, therefore, sees the reserves buildup as a biproduct.

But either way, the supply of high-powered money rose rapidly and bond yields fell. The BoJ’s QE appeared to work mainly via the “policy duration effect”– the signal that rates would remain near zero for longer than previously had been believed. The BoJ eventually got very explicit about the conditions under which it would reverse QE – i.e., only after inflation had turned positive again. The Fed hasn’t yet provided the same long-term commitment – will the end of QE be conditioned on a particular unemployment rate or inflation rate? — and may thus not get quite as much out of QE.

What are the financial market implications of QE2?
Mayer: As Peter pointed out, a key objective of QE is to raise financial and real asset prices. Through international portfolio effects, a rise in US financial asset prices will have a knock-on effect on financial asset prices in other countries. This will be augmented (and extended to real asset prices such as real estate) by the monetary policy reaction in other countries. While QE is supporting risky asset prices, such as commodities and equities, at a time when these prices seem well supported by economic fundamentals, it does so at the cost of raising most sovereign bond prices to levels not justified by economic fundamentals.

Spencer: QE2 has already had a significant positive impact on asset prices and the effective easing of monetary conditions in emerging market economies this has caused will further elevate asset prices and commodity prices and push currencies higher against the dollar. Unfortunately, in the absence of a surprise pickup in growth in the US or Europe, many of these asset prices and currencies will be pushed higher than their fundamental valuations. I’m less sure than Tom that the Fed will adjust its exit strategy to avoid a selloff in foreign asset markets. When the Fed removes this stimulus the capital flows are likely to reverse, triggering a potentially significant decline in asset/commodity prices. Ex post it will look like a bubble but over the coming months or quarters higher asset and commodity prices will appear to be justified by relative growth expectations.

Hooper: In the near term, QE2 depresses fixed income yields and the dollar and boosts equities. In the longer term, if QE2 succeeds in helping to move the US economy onto a more robust and sustainable recovery path, as I expect it will, stocks should rally further globally, yields on fixed-income securities will move substantially higher, and the dollar should regain some of the ground it has lost cyclically against major currencies.

Deutsche Bank Research