Background on Fed bond purchases

During the global financial crisis, the Federal Reserve (Fed) embarked on asset purchases, a program better known as quantitative easing (QE), primarily motivated by a complete loss of confidence in the financial system.

As a result, investors and financial institutions feared losses due to large-scale bankruptcies. Liquidity dried up completely and money was hoarded in "safe places". The Fed stepped in with various measures and effectively returned confidence to markets. Indeed QE was among these being applied for the first time in US monetary history.

The QE program was extended after the crisis in order to stimulate the economy. The Fed continued to buy assets like corporate bonds and mortgage-backed securities. As a consequence, interest yields decreased to historically low levels.

Eventually, the bulls and the bears returned back to the markets and the money that was leached to safe-haven assets searched for reinvestment opportunities. Obviously, low-interest rates across the board channelled capital into other assets i.e. equity investments prospered. Attractive valuations and dividend yields flourished and gained pace by market momentum. Hence, a large scale reallocation of liquidity took place due to this monetary policy tool.

Effects of QE

Quantitative easing isn’t automatically inflationary although believed otherwise, but rather can be viewed as a flattening of economic business cycles. Asset purchases made during an economic contraction can be undone during the succeeding economic expansion. In addition to, interest rates can be controlled through this mechanism. During expansions, liquidity can be taken out of the system again and interest rates are pushed to the upside.

In theory, the outcome of QE results is the socialisation of debt burden. Central bank exposure implies that the outcome, positive or negative, will be passed on to the taxpayer which also means that an economy can kick its debt burden longer down the road.

In practice, it is a known fact that things do not work according to plan in our complex world. This was witnessed first-hand when the central banks embarked upon such a policy. Japan was the first economic experiment involving QE which started in the early 2000’s. The Bank of Japan (BoJ) intended to fight deflation by bringing more liquidity into the system. This experiment has been going on for more than one and a half decades in Japan and still has not worked.

Seeing no inflation in Japan due to QE is actually what should rather worry central bankers applying this instrument as it implies that the measure is either fruitless or uncontrollable. Therefore, the same probably applies to economic expansions. The financial system will have an extended monetary base that is either fruitless or uncontrollable.

Western economies have reached historically high levels of leverage hence, further debt-driven growth seems less likely than a deleveraging process in the near future. Therefore, it should be quite tempting for policymakers to target a higher inflation rate along economic growth which effectively would half the total debt burden during a 10-year period.

The problem is that the complexity of the real world makes it harder to achieve this target. Moreover, there are natural conflicts of interest between politicians who get elected and long-term economic goals. Similarly, central banks around the world can expand their mandate; they are more powerful than ever before. Not only have central bank balance sheets increased but also borders of what is acceptable and what not can get easily shifted. The BoJ has, for example, bought risky assets such as equities. At the same time, they still do not have precise forecasting instruments to assess the exact stage of an economic cycle nor do they have a reliable assessment regarding the correct quantity of their policy instrument.

On another note, low interest rates lead to a reallocation of capital and dividend yields and rental yields become more attractive on a relative basis. It should be no surprise that QE has led to a bull market in equities and stopped the correction in the housing market. QE resulted in inflationary asset prices which was concentrated in economic sectors that saw expansion or particular interest from the wealthiest. Housing prices in economically affluent areas such as New York, London and Silicone Valley reached eminent levels and even created bubbles in some areas.

At the same time, it is more than questionable whether QE produced quantifiable positive outcomes for the bottom 50 per cent of the economy. IMF economists analyse why inequality threatens sustainable economic growth and development; their conclusion is that extreme inequality in the US makes major economic problems even worse.

So is QE a safe bet for a country’s economy? Probably not or perhaps it’s just not being used right.

Disclaimer:

This article was issued by Maria Fenech, investment manager support officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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