Walk into any gathering of finance professionals in any part of the world this week you are almost certain to be dragged into a discussion on the impending unleashing of another mega doze of monetary easing by the Federal Reserve, which is popularly known as quantitative easing (QE) part two, or QE2.
The debates during the past few weeks have been mostly about how much additional liquidity is going to be pumped into the US financial system as part of what some may consider to be a last-ditch effort to revive the economy.
Goldman Sachs said in a note this week that the eventual dollar amount on QE2 could be $2 (Dh 7.34) trillion when all is said and done. Bank of America Merrill Lynch sees the Fed doing quantitative easing in the neighbourhood of $1 trillion, and HSBC suggested $1.5 trillion.
But there are also a few who think that financial markets have taken the fresh wave of quantitative easing for granted when the Federal Open Market Committee (FOMC) next meets in early November.
"We believe markets may have jumped the gun. Complete unanimity inside the Fed about the nature of QE2 measures by no means is the case," Bernard Lambert and Jean-Pierre Durante, economists with Swiss Private Bank Pictet wrote in a signed note.
After FOMC's September meeting, the Fed confirmed that it was prepared to push through further monetary easing if required. It commented that this decision had been prompted just by the prolonged spell of sluggishness in the economy.
"It is going to be a market mover to say the least. But what happens to the market when the money will start to exit. That should be a cause of worry for all concerned," said Farouk Soussa, Chief Economist of Citigroup in the Middle East.
Quantitative easing involves buying large quantities of Treasury bonds, with two goals in mind. The first goal is to force long-term interest rates down and perhaps encourage borrowing and spending on big-ticket items by consumers and businesses. The second goal is to lower the interest savers earn on cash and low-risk investments, enticing them into riskier investments in commodities and stocks, thus creating a higher level of inflation that would help "inflate" the economy out of its slowdown.
Potential bubbles
Central banks usually invoke quantitative easing when the normal methods to control the money supply fail, i.e. the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero. A central bank implements QE by first crediting its own account with money it creates out of nothing.
This in simple terms means increasing the volume of money available in the financial system. Since it involves making greater quantities of dollars available in exchange for the large additional bond purchases, it also drives down the value of the dollar. That should theoretically help the US economy by making US products less expensive in foreign countries, while making imports into the US more expensive, eventually encouraging domestic consumption and manufacturing.
But when the power of liquidity plays out in the market it is not going to be that simple. To start with, it would significantly increase the massive amount of financial assets worth more than $2 trillion sitting already on the Fed's balance sheet from the first round of quantitative easing in 2008 and 2009, making it all the more difficult for the economy down the road when the Fed has to begin unloading those assets from its books.
At a global level, the implications are huge in terms of cross-border capital flows, asset prices and currency movements. While the US needs low rates, the emerging markets are experiencing a QE-led boom and potential bubbles.
The problem compounds when the newly created money starts scouting for yield across the emerging markets. Instead of going to work in the American economy, many of these extra dollars are likely to add fuel to asset prices in emerging markets and inflate the prices of commodities seen as a hedge against a falling dollar. Given low interest rates in the West and low growth prospects, the flow of liquidity into emerging markets could easily turn into a flood.
Swiss banking giant UBS reckons that the strong international capital flows that come with QE2 "will reinforce already powerful domestic credit creation in emerging markets".
That should flow through to robust, commodity intensive growth in emerging markets, while the developed world struggles in the face of higher commodity prices," UBS said in a note.
"In our view, it is the combination of strong credit growth in emerging markets, and a Fed determined to reflate a struggling US economy that will provide the impetus for an ongoing bull market in the commodities."
The obvious danger that the rush of liquidity into emerging markets and surge in commodity prices will cause these economies to overheat, driving inflation even higher. It may also aggravate global imbalances even further, leading to continued stagnation in the developed world, and a bubble in emerging economies.
There is real risk that current conditions could lead to a repeat of the commodity price-driven inflation scare world markets last experienced in 2007 and early 2008. Analysts said any repeat of such a market dislocation would likely lead to an overshoot in commodity prices driven by financial investors in commodity indices and resource stocks, and ultimately resulting in a violent sell-off. "That sell-off will again could likely be characterised by a rally in the US dollar as the carry trades are liquidated," Raman Sreedhar, a forex analyst with Federal Bank in Mumbai.
Many emerging market fund managers think a large portion of expectations linked to quantitative easing have been priced in the equity and debt valuations across the emerging markets.
"We think the markets in India have already priced in QE2 impact. Unless there is something dramatic in the announcement, the immediate impact on equity valuations across emerging markets will be sober," said Madhusudhan Kela, chief investment strategist of Reliance Capital.
Currency scare
The central banks across Asia have been cautious on the potential QE2 impact on their currencies. While most central banks in Asia have either intervened in the currency market or are prepared to do so. While Singapore has tightened its monetary policy in an effort to contain the impact of new liquidity flow, Thailand has threatened to regulate capital flows.
The Reserve Bank of India has intervened in the foreign exchange market a few times during the recent weeks to prevent the rupee appreciating against the dollar. Duvvuri Subbarao, governor of the Reserve Bank of India, said in Washington early this month that there were occasions when it might have to intervene in the foreign exchange market if capital flows disrupted the economy.
Clearly most Asian central banks have been buying dollars in anticipation of a surge in their currencies. Analysts say any let up in the QE2 plans, in terms of quantity and/or timing could witness a winding-down in emerging market equities and currencies. Markets that have factored in a substantial easing programme seemed to wonder if they might be disappointed. There was a risk that recent sentiment regarding the certainty and magnitude of future QE2 may have stretched to extremes. The gold rally seems to be losing its steam. For the first time since the bottom fell out of the dollar again, early September, the currency gained some ground last week. And even the hot stock market rally ran into unusual up-and-down volatility, seemingly uncertain about what to expect from the Fed.
The scenarios envisaged in the markets have ranged from a "shock-and-awe" type approach, in which the Fed buys upwards of $1 trillion over a set period to the regular monthly purchases of Treasuries in limited quantities.
Analysts said a repeat of the shock-and-awe stimulus Fed launched in the depths of the crisis in 2008 and 2009 is less likely. Fed officials are known to be weighing an approach that allows more discretionary meeting-by-meeting decisions.
"Fed is more likely to pursue a softly-softly approach, making announcements on a month-by-month basis adjusting the programme to the economic climate," said Pictet's Durante.
