Queen Elizabeth 2!! (Part 2)

Let us pick off from where we left last time..

Ok... I have understood what is QE and also came to understand that US is using it a second time as another last measure. I understood the why.. So, now, how is this QE actually supposed to work?

The how part is not entirely clear. In theory, it should influence the economy through a number of channels:

To start with, Fed buys the government bonds which will push their price up and the long-term interest rates down.
We all know banks. Once they are flush with cash, they are supposed to lend more of it at lower rates.
Borrowing will become easier and cheaper encouraging more people and companies to invest across fields.
The investors who sold the bonds to the Federal reserve will eventually use their cash to buy various riskier assets, as the safer government bonds are artificially made costlier by the Fed's action, resulting in the rise of their prices.
Higher asset prices make people feel richer and they spend more
Also, the circulation of more dollars will weaken the dollar value compared to other currencies, helping US exports to be more competitive in overseas markets.

And the risks?

The primary risk with implementing QE is that no one knows if it will work the way it is intended to work. There are many things that can go wrong.

Firstly, the risk of being unsuccessful.

Banks might in all probability refuse to lend the new cash as they are still worried about the loan losses. They’re already sitting on more than $1 trillion of reserves without lending it out.
Suppose, the banks agreed to lend. But still, the companies which can borrow money might refuse to invest more as the consumer spending is too weak to return the investments.
Also more importantly, it will not stop the house prices from falling further. It must be noted that this is the main reason that consumers are afraid of spending and banks are afraid of further losses.

Next, the fear of longer-term consequences:

It could be too successful, and lead to high inflation.
It could create more asset bubbles, which will eventually pop, bringing the financial system down again.
It could spark a "currency war", with other central banks trying to devalue their currencies, which could in turn descend into a damaging trade war (which is very likely considering that the two biggest economies US and China have undervalued currencies).
When the Fed tries to sell all its government bonds back to the market, it may have to do so at a much lower price, leaving it dependent on the Treasury for a bail-out .

What happened the first time US adopted this policy?

The Fed’s first round of QE was designed around a clear target amount. It first announced a purchase of up to $600 billion in assets in November 2008 and expanded that goal in March 2009 to $1.7 trillion of Treasury debt, mortgage-backed securities and debt backed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The “shock and awe” announcement, during the depths of the financial crisis, and the markets’ response before the Fed actually made its purchases helped stabilize the economy. Now, with the economy expanding slowly (but expanding), the Fed is expected to proceed with purchasing assets at a measured pace, which it may adjust as economic conditions change. And this time the Fed is only buying Treasuries, in part because some officials had misgivings about targeting a particular sector of the economy by purchasing mortgage-backed securities and in part because the first round of purchases successfully shrunk an unusually wide gap between the rates on U.S. Treasuries and rates on mortgages.

Conclusion : Like any economy, the government policies are going to play an important role in ensuring whether the recovery is full-fledged or U-shaped. It would be safe to assume that a country such as US won't be prudent to rely just on the QE for recovery. Also, QE2 is extended on over an 8 month period and so it can be pulled back in case it doesn't work or achieves early success. This is because the ultimate challenge is to spur consumption and not just huge liquidity.

P.S : The title QE2(Queen Elizabeth 2) implies a pun on the famous ship RMS Queen Elizabeth 2 - Richard Werner is a professor of International Banking at the University of Southampton, the port in which the ship was based through most of its history. However, from Prof. Werner's comments in this CNBC program it is apparent that the reason why he employed the expression was because he argued that the policy that was being called 'quantitative easing' by central banks and in the media - base money expansion and open market purchases of securities from banks - was not 'true' quantitative easing as originally defined by him, and hence likely to remain insufficient to deliver sustainable, productive and hence non-inflationary growth.

Celebrating everything,

Aravind M
http://www.aravind90.blogspot.com