On The Money

Quantitative Easing: The term sounds like something you find in the next Star Trek movie, but soon you will be finding it discussed in main stream media. Get ready for those two words to dominate the press over the next 18 months as the Federal Reserve makes its attempts to cut off the credit crunch, but don’t be surprised if Trends informed you first…

What is Quantitative Easing?

Under quantitative easing, central banks flood the banking system with masses of money to promote lending. The central banks add cash by buying up large quantities of securities — government debt, mortgages, commercial loans, even stocks — from banks’ balance sheets, giving them plenty of new money to lend.

Traditionally a central bank (i.e. The Fed), uses its rate-cutting tool to encourage lending and boost the economy. But despite a staggering 4.25% of cuts since September 2007, the economy has not improved – in fact, it has gotten worse.

Our prolonged credit crisis and eroding economy has left the Fed with few traditional arrows left in its quiver. Therefore in its recent policy statement, the Federal Reserve dropped their target Fed Funds rate to an all-time record of 0.00% to 0.25% and has announced plans to buy hundreds of billions in mortgage, credit card, student loan, and other consumer-related debt.

The goal of these programs is to take these assets off bank balance sheets and replace it with cash that can be lent out.  In essence, this replaces the securitization markets which have stopped functioning.

In theory this should work. Banks can now clear out loans sitting on their balance sheet and restock the cash available for new lending.  But there are several reasons why this might not work:

• Consumers are already saddled with record debt and may not be interested in taking on new obligations.  Consumers debt to income ratio (the percentage of income that consumers pay to debt) has risen steadily over the last 28 years to a record level in 2008.
• Banks don’t want to lend in a recessionary environment where even good credit score customers are defaulting.  No one can predict the severity of the recession.  Banks are already taking heavy losses on loans given in good times.  Their portfolios are going bad and many of their mortgage loans are souring further as housing prices continue to drop.  Unemployment is up.  It’s not the best time to be extending credit.

In the 1990s, Japan tried quantitative easing to get its economy moving and the results were mixed.  Per Bloomberg[1]:

“The Bank of Japan is the only major central bank to deploy quantitative easing in modern times, from 2001 to 2006. Current Governor Masaaki Shirakawa said in May that the policy “was very effective in stabilizing financial markets,” while at the same time it had “limited impact” in resolving Japan’s economic stagnation of the time because banks wouldn’t lend and companies wouldn’t borrow.”

There is a dark side to quantitative easing: inflation. The government has backed all of this new debt by selling Treasury Bonds, which have been the golden asset of the credit crisis. They have been the only liquid security of late, reaching historic highs as their yields have hit all-time lows.

But there will come a time when the stock market bounces back and investors will no longer be satisfied with such low returns on their investments. That would mean huge amounts of government debt with little demand left to buy it, thus resulting in a devaluing of the dollar.

So far, the dollar has held up very well throughout the credit crisis despite very low interest rates. But with countries like China and Middle Eastern countries with export-based economies facing a crisis of their own, those huge purchasers of U.S. government debt may start to ask for more return on their investment before they look elsewhere. This could be very devastating for the US economy.

It’s too soon to tell if the Fed’s Quantitative Easing will be more like giving heroin to a recovering addict or just another measured step in long recovery process. Will it make the withdrawal symptoms go away for a little while or can it permeate the underlying problem? One thing is for certain, it’s going to be another exciting year in the world of finance!