Quantitative Easing

Quantitative Easing (QE) is an unconventional method of monetary policy used by government when interest rates in an economy are at or near zero. The central bank creates money that it uses to buy government bonds and other financial assets to increase the money supply and the excess reserves of the banking system.  

QE increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

If QE works, the banks should use the additional capital available to increase business and personal lending. This in turn will allow businesses to expand and increase production. As investment and consumption improve, employment increases and the central bank will once again be able to use the monetary policy of adjusting interest rates to keep the inflation rate at an acceptable level.

The United Kingdom recently had a round of QE and no-one really knows whether QE has worked as it should. Lending is still sluggish but there are signs that QE has helped the financial markets by keeping the interest rate on government bonds low. No-one knows how bad things could have been in UK without QE.

The US has also had one major round of QE worth US$ 1.2 trillion. There is no significant indication that QE has had any effect and a second round is being contemplated.

There are two significant risks of using QE – it can either be ineffective or too effective.

Japan introduced the concept of QE to the world in 2001 in an effort to stimulate an economy that had been stagnant for almost a decade, following a stock-market crash in 1990 and a decline in real-estate prices from 1991. Government efforts to stimulate the economy have been largely unsuccessful and the Japanese have been experiencing decreasing business and household incomes for two decades now. Asset prices continue to decline, the inflation rate is negative (deflation). Two of the factors stopping Japan sliding into depression are a government policy of maintaining low unemployment and the historically strong savings patterns of Japanese. However there is no end in sight for the ongoing dormancy of the world’s third-largest economy.

If QE is ineffective in US, there are significant risks of recession and subsequent deflation. Unemployment in US was reported as being 9.4% as at December 2010 but there are some groups where unemployment is running as high as 25% (US Bureau of Labour Statistics). The benchmark interest rate is 0.25% - that is the interest being paid on government securities. Credit is still very tight and banks are either not lending money or are charging very high interest rates. The stock market is highly volatile and investors have very few options open to them. Unless the economy can be stimulated towards growth, unemployment will continue to grow and both consumption and production will slow further, setting up the conditions for a very significant recession.

If QE is too effective, and the economy takes off, there is a significant risk of high inflation which reduces the purchasing power of money. Hyperinflation (or runaway inflation) is a very real possibility. This occurred in Germany immediately prior to World War II and was one of the most important contributing factors to the rise of Hitler. Hyperinflation in Zimbabwe in recent years has resulted in an annual inflation rate of 65 milliongoogol percent – that is 65 followed by 107 zeroes. Almost without exception, abandonment of the currency has followed hyperinflationary episodes and it is often associated with political instability.

It would not take much to trigger a short and dramatic hyperinflationary episode in US. An excellent discussion of how this could happen can be found at www.businessinsider.com/how-hyperinflation-will-happen-in-america-2010.

It is to be hoped that somehow the major economies manage to walk the economic and political tightrope between the two extremes.

Source

wikipedia.org/wiki/Hyperinflation_in_Zimbabwe
www.hoisingtonmgt.com - Quarterly Review and Outlook Fourth Quarter 2010
www.businessinsider.com - How hyperinflation will happen in America 2010
www.bls.gov - Labour Force Statistics from Current Population Survey