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Research Affiliates Explains QE

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With the world’s central banks much in the news these days, and each taking different tacks, Research Affiliates has performed something of a public service by explaining quantitative easing and what investors need to watch out for.

Writing in the Newport Beach, California-based firm’s current newsletter, chief investment officer Chris Brightman sorts through what QE is and what it is not, offering some perspective on the widely varying stages of implementation among global central banks.

A key economic theme informing current policy discussions is the decline in the inflation rate, and indeed the threat of deflation.

Brightman helpfully explains that QE is not, as is often assumed, a form of money creation. It is a far more subtle monetary maneuver that the U.S. and U.K. alone adopted at the beginning of the global financial crisis that only potentially boosts the money supply and inflation.

By buying securities, QE expands a central bank’s balance sheet and simultaneously the capital reserves of its member banks.

Were those banks to start lending (and consumers start borrowing), QE could stimulate monetary growth and inflation.

However, writes Brightman, “when banks seek to increase their capital and borrowers strive to pay down their debts, QE does not increase the money supply and therefore does not cause inflation,” a phenomenon that goes by the moniker “pushing on a string.”

In the U.S. and U.K., the Fed and Bank of England (BOE) were pushing on a string, as “banks chose to hold the proceeds of QE as excess reserves rather than increasing their pace of lending and thereby creating money.”

So what did QE accomplish? At least in its earliest phase, it provided liquidity to the financial system at a crucial time when many distressed institutions were not banks, and thus lacked access to the Fed’s discount window, while banks qualified to borrow from the Fed avoided doing so, fearing the stigma of seeking government help.

The effectiveness of QE in broader economic terms including stimulating economic growth and employment, is hotly disputed. Some argue that by inflating asset prices, QE created a wealth effect, leading investors to spend more; others suggest it has distorted markets and led to malinvestment.

In contrast to liquidity-boosting, asset-inflating QE, central banks have a blunter instrument at their disposal: classic money printing. This, Brightman explains, is inflationary by definition because more money in circulation is chasing after the same amount of goods and services. Perhaps the recent experience of Zimbabwe in the 1990s, where a $100 trillion note could not buy a loaf of bread, deterred central banks from adopting this approach.

A subtler version of money printing involves monetizing the debt by purchasing government bonds whose proceeds fund government agencies. Such a maneuver provides fiscal stimulus, i.e. it is tantamount to money printing, and may cause inflation.

With this monetary policy tutorial, Brightman explains policymakers’ current choices. The U.S. and U.K. provided liquidity, banks held those reserves and inflation was not an outcome of central bank policy.

Opinion is divided on whether inflation will result if bank lending finally picks up.

Some argue that the Fed and BOE will have to mop up excess liquidity to avoid sudden, significant inflation, while others suggest there may be a technical (though politically controversial) way to avoid inflation (involving the central bank’s payment of interest to banks).

Years after QE got under way in the U.S. and U.K., the European Central Bank debuted its QE program just one week ago. Because concern runs high that EU governments already run unsustainable fiscal debts, Brightman says Europe is unlikely to pair QE with fiscal stimulus (as in the U.S. and U.K.) and will “probably be pushing on a string.”

The Bank of Japan, on the other hand, appears poised to combine both monetary and fiscal stimulus, thus monetizing government debt.

“The country seems close to testing what happens to a modern developed economy when it intentionally chooses money printing as its macroeconomic policy. Watch Japan,” Brightman warns.

— Check out Swiss Franc Move: What Does It All Mean? on ThinkAdvisor.


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