The global financial elite (G20) convened in Seoul yesterday. Among the issues being discussed, amongst others, possible coordinated action to improve global economic governance is high on the agenda.

As evidence mounts that the US and Europe are tottering about, at least on the economic growth front, many of the emerging market countries who have grown at a clipped rate are expected to demand a greater say.

Yet the atmosphere of the meet has already been vitiated due to the fierce pronouncements by various key non-American members over the proposed "quantitative expansion-2".

German Finance Minister Wolfgang Schaeuble has been reported as saying that the American policy is "clueless". Much of Europe, China, Brazil has chimed in similarly. India maintains a studious silence on these matters, despite the rupee's anticipated appreciation in excess of seven per cent over the next year.

QE2 is the programme where the Federal Reserve will buy Treasuries or other corporate debt securities in exchange for cash. Where will the Fed pay for this? The answer is from nowhere and everywhere.

A computer entry will manufacture monies into the accounts of the agencies they decide to buy from. With real American goods exports flat, increasing the quanta of money in the system will arguably do two things.

One, increase price levels and two, lower the relative value of the dollar against other currencies. Predictably, those who are long the dollar (betting that the dollar will increase it's relative value) are crying hoarse against this policy.

Four principal rationales

Yet, one must ask whether American policymakers see the impact of these moves. The answer is, well, yes of course.

In a recent speech, the President of the Minneapolis Federal Reserve Narayana Kocherlakota made an effort to explain their rationale. All indicate that the end game is manufacturing inflation to avoid a Japan-in-1990s-style-deflation.

There are four principal rationales that the Fed is guided by. First is the transfer of risk. When the Fed buys long dated securities from the private sector in exchange of cash or short-dated deposits, the long term interest rate risk is transferred to a public agency.

To manage their portfolios the private sector will purchase long dated bonds (now, in short supply due to the Fed's purchase). This will bid prices up and lower long term yields.

Given low yields, this will arguably spur investments in the real sector. A subtler second point has yet to be argued or debated, especially among the opponents of the QE2 programme: whether this is the efficient thing to do or not is unclear.

More interestingly if the cost of risk is artificially reduced, will the economy continue to misallocate resources? The only answer is "no one really knows"! The Fed is flying in blind, and so is the rest of the world.

The third critical point the Fed is trying to do is show it's commitment to a future with low interest rates.

When the Fed pays private banks to hold their securities, it is in effect exchanging their long-dated securities for the Fed's short-dated assets that are deposits/cash holdings.

The banks in turn keep a fraction of their funds with the Fed as part of the reserve requirement. So, should the short-term rates increase, the Fed would be forced to pay a higher rate to the banks and thus suffer capital losses.

Like any bank, the Fed wouldn't want to suffer losses. It is in effect telling the larger world that it is unlikely to raise rates no matter what.

 

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.