While announcing the rollout of the third round of quantitative easing (QE3), by far the most aggressive monetary policy support since 2008, US Federal Reserve Chairman Ben Bernanke acknowledged that “monetary policy, particularly in the current circumstances, cannot cure all economic ills”. By all accounts US economic recovery is tied to resolving deep structural problems. Meanwhile, US policy makers are pulling all stops to speed up from the 1.7 percent second quarter GDP growth and lower the current 8.1 percent unemployment rate.
“The lack of robust growth leaves the Fed with little choice but to do something,” said Viral Acharya, professor of finance, New York University. “But as officials have acknowledged, the problems seem likely structural and call for more long-term solutions in the form of improvements in education, match between skills and available jobs, as well as a credible plan for substantial fiscal deficits.”
While QE1 aimed to ease credit flow and QE2 targeted deflationary pressures, QE3 seeks to boost the labour market through the purchase of mortgage-based securities (MBS) at $40 billion per month until the economy recovers.
What’s extraordinary is the policy’s open-endedness. By stating its commitment to keep long-term interest rates low for as long as it takes, the Fed injected confidence and a sense of certainty amid several uncertain economic variables.
Following the announcement, the KBW bank index rose 2.8 percent, the Dow climbed 210 points, and given the possible spillover effects, the Bombay Stock Exchange’s 30-share Sensitive Index by 180 points. “Risk assets were right to rally as the Fed is signalling that it will be injecting an enormous amount of liquidity into the market over the next 12 to 18 months,” said Jeremy Lawson, senior US economist at BNP Paribas. Lawson believes it will boost economic and employment growth over the next few years, even though monetary policy is not going to cure the economy’s ills when structural reforms are necessary.
But opinion is divided over QE3’s effectiveness in comparison to its magnitude. “Much stimulus has already been provided to the housing market through conservatorship of Fannie Mae and Freddie Mac, as well as partially successful programmes to help indebted households with their mortgage payment burden,” said Acharya. “Hence, any incremental impact of QE3 is at best likely to be marginal.”
Arvind Krishnamurthy, professor of finance at Northwestern University, also anticipates the impact of QE3 to be smaller compared to MBS purchases under QE1. However, he points out that following the recent announcement, MBS yields fell by about 0.25 percent and the lower yields would be transferred to home buyers through bank mortgage rates.
According to Experian, the average personal credit score is 736, implying that despite tighter banking regulations, many individuals with stable incomes are eligible to obtain home loans or refinance existing mortgages. The policy will not make any difference immediately to those with a poor debt history but it will help them buy time to improve their credit scores.
For borrowers saddled with prospects of increased taxes in the future and lacklustre growth in income, the opportunity cost of spending today is cutting back on spending tomorrow. For retirees on fixed income, the low interest is a poor reward for a lifetime of hard work and prudent savings.
The continued downward pressure on the dollar is expected to push a section of investors to alternative channels, which may explain the 2 percent surge in gold prices from the morning of the announcement to the day’s end.
Concerns abound on price hikes in dollar-denominated crude, which briefly crossed $100 per barrel post the QE3 rollout.
“Monetary easing in the US should make higher-yielding India assets attractive to US investors,” said Sheraz Mian, director of research, Zacks Investment Research. “What happens in reality, however, will depend on a number of factors, including the attractiveness of the Indian market relative to other emerging markets.”
After months of dithering, last week India opened up some key sectors such as civil aviation and multi-brand retailing to foreign investment and has promised more ‘nuts-and-bolts reforms’. That could restore its competitive edge as it still holds the potential to deliver high returns to investors.
Jonathan Ostry, deputy director of research at the International Monetary Fund, points out that previous rounds of quantitative support from the government did not influence capital flows to emerging market economies (EMEs) very much, though they would have had some effects to the degree monetary policy encouraged increased purchases of riskier assets, including foreign assets.
“There is also more broadly a long-standing literature that shows that interest rates in key financial centres have a material impact on capital flows to emerging market countries. I see the effects of QE as operating primarily through price channels, but clearly not short-term interest rates which are already zero.”
The spillover effect from QE3 for India, which has its own set of structural problems, could be multi-dimensional. He says a more robust recovery in the US would help EMEs through trade channels, and this should be offset against any additional financial stability challenges that arise if inflows surge. “EMEs in turn have policy tools at their disposal to manage those additional risks, and they should use them.”