Thursday, April 28, 2011

Quantitative Easing

Humility is important; with that in mind I must say that I had misunderstood quantitative easing, and that being said, most people misunderstand QE. QE is not 'printing of money' and QE does not stimulate the economy directly and QE does not increase money supply drastically.

I read this smart piece today which simplifies things.
In essence, what QE enables (in the case of US) is the Federal Reserve (Central Bank) to purchase long-term treasuries from the government through the secondary market. The shorter end of the yield curve is already controlled by the Fed in what can be called Open Market Operations; however, investor perceptions of inflation and future short-term rates can move the longer end of the yield curve.
Today, the longer end (10-year) would have moved beyond 4% yields. However, by purchasing close to 70% of the total treasury issuances, the Fed artificially drives up prices (and reduces 10-year yields). This enables the 'system' to provide cheaper long term credit to companies in the economy and this would help stimulate economic activity (as cheaper money is always good for stimulating consumption).

With a Federal Reserve, implied, assurance of maintaining long term rates at low levels and explicit assurance of keeping short term rates really low, a carry trade allows cheap money to chase assets globally.
This can significantly explain increasing prices of various commodities and other asset classes.

When will the buck stop? Clearly, the Fed cannot risk an end to QE. QE3 will happen, but at what cost? I see that soon, investors will cry foul at the power that America wields over the global reserve currency.

2 comments:

  1. what the QE is basically doing is increasing liquidity in the market, which is pretty similar to printing money (coz eventually it is lot of money at low cost chasing limited resources). so when QE stops, the fed will suck out the money which it had pumped either by printing money or not

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  2. What needs to be understood is that the money is not reaching the public, nor is it reaching the banks. However, because long-term rates are kept low, lending is encouraged. Since the money is not being lent to businesses as much as the Fed would hope, the money is being used by financial institutions as leverage.
    When the QE stops - IF the QE stops. We aren't certain yet. The Fed has already said that maturities will be ploughed back into treasuries and is ready to take steps if need be. The Fed isn't going to 'suck out' money any time soon... The secondary markets are still too fragile for MBSs and bonds. The Fed sucking money out will depress bond prices, something it has been working against for a long time now.

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