Wednesday, 26 October 2011

What has quantitative easing actually achieved?

Earlier this month we enjoyed having the opportunity to talk to clients of our Leeds office. The event was highly interactive with plenty of questions - perhaps underlining that, as per the old Chinese curse, we may live in interesting times!

One of the most common questions was: what has quantitative easing actually achieved? Some potential answers are discussed below - illustrated using the Federal Reserve's own economic database (sentimentally named FRED).

Increasing bank lending

Quantitative easing provoked advocates and antagonists to proclaim it a monetary policy - by buying assets from banks, money is injected into the financial system, spurring inflation and maybe growth. After the event, however, there has been little evidence to support this function. The cash received through their sales of securities have simply been held on bank balance sheets as what are known as "excess reserves".

This should be a blow to policymakers. Banks make money by receiving short term deposits and making long term loans (discussed previously). Regulators require banks to hold some of their assets as reserves to make sure they can repay everyone who might reasonably withdraw their deposits. Because they earn little interest on reserves, banks ought to hold the lowest reserves they can. Their decision to hold more reserves than they are obliged to reflects a reluctance to take on credit risk. The graph below shows that the household mortgage sector has been shrinking since 2006 (the red line, using the right hand scale, shows the rate at which the mortgage sector grows each year). Meanwhile excess reserves have grown spectacularly.

Lowering borrowing rates

This was the principle reason for QE1 in the states, which aimed to drive down mortgage rates. It was also the aim of its later variation, operation twist.

Whether through QE, more conventional monetary policy (like stating that interest rates will remain on hold for an extended period), or more general risk aversion, lower borrowing rates have become available as the graph below demonstrates.

Past Performance is not a guide to future performance

Have these policies worked? Consumer credit is recovering but remains way below its pre-credit crunch peak. Real estate loans, however, continue to decline despite the attractive rates available.

Economic uncertainty restricts demand for loans while the prevalence of negative equity means many homeowners simply don't have the security to refinance.

A positive wealth effect

The fabled "Greenspan put" is a phrase used to describe how former Chairman Greenspan would use monetary policy to bolster the stockmarket when the economic outlook looked bleak. An increase in the S&P 500, the policymakers reason, increases the nation's confidence and their wealth, encouraging them to go shopping. Initial market reactions to the first two tranches of quantitative easing were positive. The reaction to Operation Twist was less so (as we discussed in bitter and twisted).

Weakening the currency

While the UK authorities have been quite outspoken about the benefits a weaker pound will confer upon the economy, in the US a weak dollar is seen as a sign of weakness (and a cause of higher gasoline prices). So policymakers continue to espouse a strong dollar while their actions systematically undermine it.

Past Performance is not a guide to future performance

That unspoken policy, at least, appears linked to the bouts of QE the Fed has enacted. The blue line in the graph above shows the Fed's QE purchases (treasuries and mortgage backed securities) coincide with weak periods for the dollar relative to its trading partners (the red line on the right hand scale).

As we shall comment in future posts, the benefits of any lasting depreciation would be significant - although they accrue more slowly than some of the other hoped-for benefits of QE.


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