Wednesday, 29 October 2014

Time up for QE

No one really understands it and because of this opinions are all the more divided and intransigent. Despite this incoherence the market has understood enough to know that it drives asset prices and confidence in future prices.  It is QE – quantitative easing.

Ben Bernanke - the Godfather of QE

QE is where Central Banks print themselves some money to buy bonds and other instruments from the banks, the idea is that this puts cash / liquidity into the economy increasing the money supply and making credit more freely available.  Under “normal” conditions of growth (+2-3% annually)and inflation (around 2% annually) equilibrium this would drive up aggregate demand (growth)  and inflation as the banks push this extra liquidity out into the market in the form of loans.

For more or less the whole recent period of QE, where the US, Japanese, European and UK central banks have poured $2tn of new money into the world economy, we have not had “normal” conditions as growth has been well below trend and inflation has also well below the targets set by governments.  As a result it has been very difficult to measure the impact of this new liquidity.  There are 10 of things that we can now say with some certainty:
1. QE did not create the wild inflation that many monetarist believed would result
2. QE reduced long-term real interest rates and borrowing has become cheaper.
3. QE created looser monetary policy over the past five years, without which the world economy  would have delivered lower growth and higher unemployment overall
4. QE has made borrowing easier but the appetite for credit is waning
5. QE has helped sustain and increase asset prices
6. QE on its own did not solve the problem – we still have lower than trend economic growth, private investment is still at an historic low and Europe is flirting with deflation
7. QE may well have made things a little better than they might have been – the initial rounds certainly propped up a badly listing banking sector
8. QE may has made planet an even less equal society as  owners of capital benefited from asset  price rises and wages for labour have been depressed
9. QE has provided an endless source of fun for economist around the world
10. QE is a puzzle and the fun bit is about to start.

Even though we “know” all this stuff about the short term effects of QE what do we think will happen next?  It may be most fruitful to look at this in a chronology.

Step 1 (now) – Asset prices globally will fall – stocks, bonds, property, wine – you name it prices will be falling for the next 6-12 months

Step 2 – As asset prices fall there will be a nasty sting in the tail for the banks that still harbour vast swathes of distressed debts.  This will cause further tightening of credit markets and banks run up against the higher (new defined) thresholds for regulatory capital (cash and securities thy have to hold to support their loans and other trading)

Step 3 – This squeeze on capital in the banks will put a further break on growth and inflation. Unemployment will also rise and political institutions will come under pressure (the Eurozone will be under the spotlight again)

Step 4 – Just as it looks like the world will come to an end, low interest rates and cheap asset prices will create the conditions we need for recovery and recovery will come!

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