- The Fed’s Quantitative Easing

Don’t you wish you could add a few zeros to your online bank balance? Try it and the cops will be at your doorstep with handcuffs. But the Fed can create and spend money. Under the right circumstances investors will applaud. What are the right conditions? One is a severe recession. Normally, a central bank stimulates an economy in recession by lowering interest rates. When it cannot lower them any further it can attempt to lubricate the financial system with new money. Not paper money, but electronic credits.

As part of its quantitative easing policy to provide support to housing markets and mortgage lending and to bolster private credit markets, the Fed's balance sheet has swelled to more than $2 trillion from about $869 billion in 2007. By the end of the year the Fed intends to purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Federal Reserve will also buy up to $300 billion of Treasury securities.

This federal shopping spree is supposed to encourage lending and reduce the cost of borrowing, thereby stimulating the increase in the overall money supply through deposit multiplication.

Risk and Reward

But for every medicine administered there may an allergic reaction. Some analysts say that by creating cash for the Federal Reserve to purchase securities and debt, the US Treasury is monetizing the government deficit. Risks to quantitative easing include higher inflation than desired or even hyperinflation if it is improperly used and too much money is created. The risks come when the economy recovers and inflation starts to become a liability rather than an anticipated outcome. There will come a time when the Fed wants to withdraw those extra trillions of money it created. One way it will do this is by selling back to the private sector the bonds it bought.

By diluting the value of a unit of currency, the increase in money supply has a desired inflationary effect. But people who have saved money will find it is devalued by inflation, and the associated low interest rates will make life difficult for people who rely on their savings. There is also a risk that banks will still refuse to lend despite the increase in their deposits, or that the policy will be too effective, leading in a worst case scenario to hyperinflation.

The Near-Term Course

The easy job for Fed Chairman Ben Bernanke was flooding the US economy with money. The challenge – when to withdraw funds – will soon begin. A return to recession could be triggered if the Fed withdraws its huge cash injections too soon. But if the Fed withdraws funds too late, inflation could re-heat.

The Federal Reserve is no doubt considering the long-term implications of quantitative easing, and will certainly formulate an exit strategy before investors start questioning its policy mechanisms to achieve sustainable growth. The price of oil and gold suggest that the world has too many dollars and it is time to pull back. But high unemployment levels and a fragile US economic recovery argue against a withdrawal of funds at the present time.

The US public debt now stands at $11 trillion, and is continuing to increase an average of $3.92 billion per day. Since more money will be available for the same quantity of goods, inflation will spike higher. Inflation fears could force the Fed to increase the benchmark interest rate, which could inhibit growth and plunge the US economy into stagflation. Several months of quantitative easing combined with expectations for a record government budget deficit are already taking its toll in the dollar exchange rate. In the long term, continued economic growth in the United States is likely to influence the Federal Reserve monetary policy and lead to a positive shift of interest rate differentials in favor of the US dollar.

Volatility and YTD return of a selection of inflation-exposed commodity and index futures from Jan 2009 to present generated using the RiskAPI Add-In.

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