Smart Investor: Getting Started, September 2013

Smart Investor, September 2013

Getting Started

It is a term so widely used it has become an unquestioned abbreviation. Even when applied half a world away, it appears to dictate our currency, our interest rates and the health of our exporters. It has swallowed trillions of dollars of American, British and Japanese money. But what exactly is quantitative easing, or QE?

QE is an emergency measure to help an economy, and in particular its financial services industry, through drastic means.

Normally, central banks – institutions like the Reserve Bank of Australia, Federal Reserve or the Bank of England – perform their main function by raising or cutting interest rates. This is normally a sufficient tool for what central banks need to do if they want to have an influence on the amount of lending and activity in their economy, and perhaps upon the value of the currency. Raising interest rates makes it less attractive to borrow (because a loan becomes more expensive) so can cool down an economy in which people are over-extending themselves or where asset bubbles seem to be falling. Cutting interest rates usually encourages people to spend, galvanising the economy. But what if, as in the US, UK and Japan, interest rates can’t go any lower? What if they’re already at the bottom?

 This is where QE comes in. Basically, it means pumping money into the economy directly. Specifically, it means buying assets, usually government bonds but potentially other assets too, sold by commercial banks or insurers. It does this using money the central bank has created out of nothing – printing money, you might say, though these days there’s no printing involved. The idea is that interest rates stay low, which should help companies and households; but by buying assets, the central bank should also cause the value of those assets to increase. That, in turn, should encourage greater spending and demand, in order to pull an economy out of recession.

There are some precedents for this, some good, some bad. Japan tried it with some limited success in the 1990s to get out of a period of deflation after the crash of its real estate market (and has more recently become the latest country to try it again). In other places, printing money has proven disastrous, creating hyperinflation, as in Germany between the world wars, or more recently Zimbabwe. The argument is that this time it’s different: the printing of money is being done to get out of deflation, rather than to finance a government deficit, and is intended to be temporary. It will be a long while before we can conclude convincingly whether the idea worked this time around.

After all, in the United States, QE began in 2008 and is still going on. In November 2008, three months after the collapse of Lehman Brothers, the Fed began spending $100 billion a month to purchase mortgage-backed securities over 17 months, spending US$1.7 trillion in total. These days, we look back upon this as QE1. A second round followed from November 2010 to June 2011, with the Fed spending US$85 billion a month for seven months. This time, the Fed was buying up treasuries rather than the toxic mortgage backed securities of the first round. QE3, which pledged to carry on buying mortgage-backed securities indefinitely, then followed in 2012, and proponents of the strategy will tell you this caused the US housing market to rebound. Some feel that QE3 is still going; others believe it turned into something new, QE4, following an announcement that QE would continue until unemployment fell below 6.5% or core inflation rose above 2.5%.

Elsewhere, in the UK the Bank of England began its own asset purchases in January 2009, which so far have involved £375 billion of commitment; and this year Japan started its own programme.

Over time, debate has moved from the impact of QE to the impact of ending it – or tapering, as the withdrawal of QE is commonly referred to. Even if markets have their doubts about the usefulness of QE, that’s nothing compared to their fear of withdrawal pangs: when Ben Bernanke, chairman of the Federal Reserve, made comments on June 19 suggesting it would start to reduce and eventually end its asset purchases, $3 trillion was wiped off world stock markets over the next five days.

Nevertheless, it has to happen: QE can’t last forever, and it has risks. One of the challenges of QE is that a central bank can lose money – money that ultimately will have to be funded by taxpayers – on its purchases. Another is that if a central bank goes too far, it can destroy the value of its currency – which in the short term can be quite useful to help exporters (and indeed has been an intended consequence of QE in the US and Japan in particular) but must not continue unbridled. There is a tricky balancing act here, as mild QE won’t have any impact at all, and too aggressive QE can cause other problems. Japan’s recent approach shows that central banks are tending towards aggression.

So Bernanke saying QE will come to an end should be no surprise, it’s just that nobody’s looking forward to it. Experts say that QE won’t end unless the economy is strong enough to support it, and that there should therefore be nothing to worry about in the long term, but the process will be rocky. Bernanke’s June 19 comments said that QE was dependent on incoming data, and that improvements in the US economy would likely prompt him to begin tapering before the end of 2013, ending it entirely in 2014. How we view that depends on whether we are glass is half-full or half-empty sort of people: an end to QE means the economy is in better shape; but it also means months of volatility while the market suffers from the withdrawal.