Macroeconomics primer: How quantitative easing affects loans, cash, investments and the economy

Definition:

Quantitative easing can be defined as the introduction of new money into the money supply of an economy. In a central banks’ balance sheet, it has the option of either purchasing or selling government bonds in the open market. Rather than utilize this traditional monetary option, the central bank decides to buy the bonds of banks and debt instruments of other corporations.

Learning doesn't end.

Credit: Diego Muller on Flickr

Why implement quantitative easing

When the economy is in a crisis and the conventional attempts to revive it using monetary or fiscal policies have failed, the central bank might be called upon to experiment with a quantitative easing.

As the central bank buys corporate bonds and assets, the prices of these instruments rise while their yields fall. Therefore, the cost of borrowing for businesses and households falls. It is expected that when the banks and other financial institutions lend these money, investments will increase.

These fall in cost of borrowing and availability of easy money for lending increases liquidity in the economy. Liquidity refers to the availability of liquid cash in the economy. As we know, cash is an engine for activity. Availability of these cash is expected to revive the already comatose economy.

On the consumers’ side, there is much money to buy new houses and non-durable goods like cars, toys, computers, laptops, video players etc. Therefore, demand on the aggregate in the economy is expected to rise.

This expected rise in aggregate demand makes businesses borrow money in order to anticipate high demand for their products. Therefore, competitive pressures increases and many companies reduce the prices of their goods in order to gain market share and make more profit.

Eventually, when businesses start making profits, employees or workers start asking for an increase in salary. Eventually, producers raise their prices in order to meet up with the increased wages they are paying and prices rise again. Employees once again ask for higher salaries and to meet up the demand, producers increases the prices of their goods. Eventually, the increase in prices is expected to stabilize.

Therefore, inflation, a general increase in prices and fall in the purchasing value of money, is what central banks expect when quantitative easing programs are introduced.

The above scenario is what makes the economy vibrant after it has been tepid following a financial crisis.

But sometimes it doesn’t work out as in a fairy tale!

Sometimes, it doesn’t work out as calculated.

1. Cash hoarding:

Instead of spending the extra cash in their hands, businesses and households might decide to hoard it. That is, they might decide to amass it. Don’t blame them. After going through a financial crisis where money is hard to find, having easy money is too good to be true and losing it becomes a difficulty. When cash is hoarded, the economy finds itself in a liquidity trap. The expected increase in demand does not kick off.

2. Inequality increases:

It might increase inequality in the economy. The rich in any economy own more stocks and shares; they own more property like houses; they have access to bonds and corporate debt instruments. As the prices of these items increase, their wealth increases, increasing the inequality gap in the country.

3. Extraneous factors:

If eventually fall in prices is not in response to quantitative easing but due to something else, like a fall in the prices of commodities or resources used in the production process, inflation, or the increase in prices as predicted by the central bank, might not really be boosted. Instead, the existence of easy money might cause deflation, a reduction in the general level of prices, rather than inflation.

Overall, quantitative easing is introduced by central banks only when all other conventional monetary policy options have failed or will fail.

Oil price uncertainty (1): Monetary and fiscal policies might arrive too late to be effective.

The slightly more than fifty percent (50%) fall in oil prices since June 2014 seems etched in stone. Oil prices are dipping. To shore up prices, oil exporters are relying on supply side economics. The market is not well understood. When major OPEC countries are sticking to their guns rather than implement expected production cuts, it could only be opined that uncertainty rides the market.

The steep fall of oil prices since June 2014!

Source: Investing.com

For the past nine months, the news is beset with falling oil prices followed by reduction in energy bills – gasoline prices have fallen, fuel prices at the stations have fallen, prices of non-durable goods have also followed suit. Consumers seem to be having a good time. Income after taxes and transfers, what is called disposable income, is now worth more. Globally, the fall in oil prices have benefited consumers. It is estimated that the increase in global GDP due to a decline in oil prices should be around 0.7-0.8%.

But it’s not alright on the economic front for both oil importing and exporting countries despite the burgeoning demand. The sweet story resides in the short-term. What really matters is the medium and long-term effects of a sustained and unrelenting fall in oil prices. What would a Central Banker do if reducing costs of production passes through declining inflation?

According to Raju Huidrom, “the U.S. Federal Reserve has typically chosen to respond vigorously to inflation increases triggered by higher oil prices but has responded less to unexpected declines in inflation following oil price declines.” Expected monetary expansion are already been put in place.

The European Central Bank’s quantitative easing program will give more liquidity to the banks and make the prices on corporate assets rise while their yields fall, therefore kicking in expected increases in investment. It is rumored that Israel might start a quantitative easing program soon.

But the problem, as foreseen in the recent OECD’s interim assessment report that was released last week is that expected investment increases might not be in the right channels. Increased capital expenditures and increased consumption of durable goods is a monetary policy goal but the market might not give them victory on a platter of gold. According to the OECD, the market is not operating on fundamentals.

Therefore, it is advised that fiscal policy should be used to strengthen and safeguard monetary policy. Reduction in the budget deficits of most developed countries and the BRIC countries would be desirable. Spending cuts in government are not easy to implement. It takes a long time. It takes strong political willpower. Even Nigeria, one of the foremost oil exporting member of OPEC, has been rumored to warn civil servants that to kick in spending cuts, they might have to accept some retrenchment.

If oil prices continue to remain adamant, the market will have to surrender to uncertainty. Except OPEC countries like Saudi Arabia agree to production cuts that should prop up oil prices.

Next in the series: Oil price uncertainty (2): Attired as a bear.

If America doesn’t want more power, no country is more willing to take it away than… you guessed right!

The Economic Power Button?

Credit: Frédéric BISSON on flickr.

Speculation is rife that the Federal Reserve’s policy meeting tomorrow will occasion the announcement of a rise in interest rates. It’s not speculation because reading today’s news points to that fact.

First, the dollar is very strong and will get stronger. The real exchange rate, not just the nominal one, is also high, propped up by falling oil prices and a weak inflation in the country.

Second, the quantitative easing regime which the European Central bank just kicked in last week will make European corporate stocks very attractive. If the Fed doesn’t raise interest rates soon, investors might push their money towards Europe and they’ll be the loser for it if the euro appreciates in the near future.

As I mentioned before, falling oil prices means the cost of production is falling globally. Too bad for OPEC countries! Profits will soar and there will be more money in the hands of American citizens. Employment is not a big issue; it’s a political advantage for President Obama.

Take a happy workforce with money in their pockets, corporations posting profits and a financial system that is one of the best in the largest economy in the world and there’s only one way to go – hold on to that power.

Holding off raising interest rates might seem a strategic option, but that option will leave Americans with no option but to import goods and more foreign goods. They’d rather export financial assets and make the balance sheets cleaner. On the other hand, raising rates makes American citizens stronger and corporations more competitive.

So, which way would the Fed go: take a hawkish tone and watch as the markets unfold post Eurozone’s quantitative easing, or take the plunge, do what the markets expect? It could be any one’s guess.

Is Africa going to have free money?

All that glitters is not gold.

Photo Credit: SBC9 via Compfight cc

The ECB announced recently that it’ll kick off its 60 billion euro-a-month bond purchases ($66.3 bn) today. This stimulus program, a quantitative easing, is expected to involve euro-denominated public sector securities in the secondary market, as well as securities from the corporate arena such as asset-backed securities.

Quantitative easing, not new to most Central Banks these days, although common with Japan some decades ago, is a monetary policy undertaken by Central Banks when the standard monetary policy, purchasing bonds and thereby expanding the money supply, has proved ineffective. In recent years, we have seen European countries reduce their rates to much below the lower bound, to negative values.

Why quantitative easing? As I said earlier, because standard monetary policy has failed. When Central Banks are purchasing corporate bonds and assets in lieu of its own issued bonds, the prices of those assets rise and their yields fall. The monetary base increases and thence the money supply. That means there will be much money in circulation. Many persons claim this is tantamount to printing money. It is also done to stimulate spending, discourage savings and stimulate the economy to a recovery. Eventually, all these measures prove effective when banks lend this liquid money.

Quantitative easing is also used to curtail deflationary pressures on the economy.

So, with banks having high liquidity, they’re ready to give out money both locally and globally. Africa will not be left out of the lending spree.

Nigeria, South Africa, Ghana, Kenya and other African economies that have been in favorable ratings recently will expect to receive European money as loans. Will it be free?

Even when those lending rates are low, it is not free. Like in the past, it could create a spirit of “cheap loans” amongst developing country borrowers, making them increase their debt portfolio unreasonably. To maintain or increase growth, they’d have to do with some rise in inflation. Not so bad, though.

Until European recovery occurs as expected.

Too bad if the Governors of African Central Banks are not prudent. A former Indian foreign secretary, Shyam Saran, believes most of this money flowing to developing economies will be in portfolios, and not foreign direct investments. Thence, developing countries have to anticipate distortions and manage them appropriately. Portfolio investments can take flight on a whim. African economies do not have the investment climate that fosters much confidence.

Policy responses by developing countries matter when European economies start going back to tighter monetary policies. African economies should be expecting negative spillover effects when this happens. Capital inflows will reduce. Although this might not be significant but they are cautioned to exercise prudential economic management and investment in the sectors that will best allow structural change.

So, the money will not be free after all. The ECB is looking for a way to give herself time to bounce back and be competitive again.