Abheek Barua & Shivom Chakravarti: To QE or not to QE

Can a third round of quantitative easing by the Federal Reserve help stabilise the economy and markets?

Global markets endured another painful fortnight as weak data revived fears of a global recession. At the same time, Standard and Poor’s (S&P) downgrade of US government bonds and the uneasiness over the credit-worthiness of European heavyweights like France underscored the fact that policy responses on both sides of the Atlantic are falling short of the challenge. The result was a sharp rise in risk-aversion among investors and the impact on the US dollar of S&P’s decision to downgrade US sovereign ratings turned out to be somewhat perverse.

Instead of coming under pressure, the dollar actually benefited from inflows into US treasuries that sought a “safe-haven” trade. US treasury securities rallied after the decision with the 10-year bond yields moving down from 2.56 per cent to the two per cent mark where they currently dwell. Clearly, investors lack viable alternatives to the greenback and the dollar remains the currency of choice in periods of acute risk-aversion. Global equity markets led the sell-off in assets as global investors downgraded their long-term assessment of the global economy. Their specific fear seems to be that fiscal consolidation in the G3 regions at a time when the private sector and households are still paring their balance sheets could bring on another sharp downturn.

The majority of analysts now believe that the onus is now on monetary policy to cushion some of the blow from fiscal contraction and predict another round of dollar infusion (quantitative easing or QE) by its central bank, the Federal Reserve. But the Fed can justify QE3 only if it can convince the markets and policy-makers that the earlier avatars of QE actually helped stabilise the economy and markets. The question is: can it?

The first round of QE was announced in response to the financial crisis back in 2008. The programme was successful, at least in reviving the financial markets and reducing the huge premiums (credit spreads) that risk-averse lenders were charging. To the extent that financial stability itself lends a hand in reviving the global economy, QE1 seems to have played its role. For instance, the TED spread (that is the three-month dollar Libor rate minus the three-month treasury bill) that is used to judge credit risk in the system softened from 458 basis points (bps) to 20 bps by end-2009. In 2010, the Federal Reserve justified the introduction of QE2 on the grounds that it had fallen way short on its objectives of price stability and unemployment. But the specific problem with price stability was not one of impending inflation but rather the risk of deflation, a government’s worse nightmare when it is sitting on mounds of debt and planning to borrow more. Core inflation (inflation net of food and fuel prices) had slipped below one per cent and was declining steadily, while the unemployment rate at over nine per cent was way above the targeted “natural” rate of 5.5 to six per cent.

Did QE2 meet its objectives? Clearly QE2 did not deliver on the employment front. The latest print for unemployment (for July) is 9.2 per cent. However, credit off-take by American businesses did pick up after the introduction of QE2 perhaps on the back of soft rates and the easy availability of money. While credit growth has dipped subsequently, it is possible to argue that if the Fed kept its monetary taps turned on, it would have spurred credit growth that would ultimately seep into the labour markets as businesses began to hire. One could also argue that were it not for the supply disruptions that the earthquake in Japan brought on or the spike in oil prices that the turn of events in North Africa and West Asia triggered, QE2 would have fared much better in propping up the economy. On the price front, its success was more visible. Core consumer price index inflation is currently at 1.8 per cent, more than double of what it was last year. Deflation is no longer a clear and present danger.

One could argue that if fiscal contraction does pull growth and demand further in the US, the Fed policy will face challenges similar to the ones that brought on QE2. Thus, votaries of quantitative easing (that includes Fed chairman Ben Bernanke) do have a case for resurrecting this policy. However, this case is far from watertight as the resistance to more monetary easing from three of Bernanke’s colleagues in the recent high-power Federal Open Market Committee (FOMC) meeting suggests. But despite this opposition to an easy money policy, Bernanke did commit to keeping policy rates on hold until mid-2013. If indeed prices start softening in response to weaker growth, there is likely to be more agreement on the need for QE3. This is possible by the end of this year.

More dollars in the market means a natural tendency for the dollar to depreciate. Thus, by the end of the year or the first quarter of the next, (assuming, of course, that QE3 happens) the dollar could shed some of its recent gains. An abundance of dollars will also tend to push up other asset prices including emerging market stocks and currencies. Thus, the rupee and the Sensex might see some reprieve from the merciless battering that it is currently receiving as the year comes to a close. Some would argue that the markets need not have to wait that long. If Bernanke begins to articulate a case for the third round of QE, investors might begin to “price” this in ahead of the actual announcement. Thus, it might not be doomsday just yet.

The writers are with HDFC Bank. These views are personal