Theodore Gilliland
Quantitative Easing

Q&A on QE2

By, 12/06/2010

On November 3rd, the US Federal Reserve announced it would purchase $600 billion in long-term Treasury securities over the next year at a pace of about $75 billion per month. The Fed hopes pumping cash into the economy and lowering long-term interest rates—called quantitative easing, or QE2, as this is the Fed's second go-round—will reduce deflation risk, bolster economic growth, and lower unemployment. But QE2 has elicited sharp criticism from pundits, policymakers, and economists at home and abroad.

Much of the debate is ideologically charged. The following attempts to strip away the rhetoric and provide common sense answers to questions that matter to investors.  


Q: Will QE2 bolster the US economy?


A: Probably not much, but it may support stock prices.


QE2 will likely have a limited incremental impact on US economic growth and credit availability, both of which will likely continue growing regardless. The problem today isn't too little money. The financial sector already has more than $1 trillion in excess bank reserves, and there's no clear reason to believe adding more liquidity to the banking system will do any good. Rather, the issue is the rate at which money is spent—the velocity of money. Velocity will naturally recover as banks increase lending to consumers and small businesses and corporations gain the confidence in the global economic recovery to deploy their cash-rich balance sheets in hiring and investment—not because of QE2. However, $75 billion a month for the next year has to go somewhere—and that somewhere will likely be financial markets, at least in the near term, possibly providing some support to stock prices.


Q: Will QE2 result in high inflation?


A: Not likely anytime soon.


Critics contend significant monetary expansion will inevitably lead to higher inflation. As Milton Friedman once said, "Inflation is always and everywhere a monetary phenomenon." Indeed, more money chasing the same amount of goods puts upward pressure on prices. But so far there's no evidence of inordinate inflation. Consumer price inflation was just 0.6% year-over-year in October—the slowest rate since records began in 1957.


Moreover, high inflation is unlikely in the near term. While inflation is almost always caused by monetary expansion, monetary expansion doesn't always lead to inflation. Inflationary pressure can be offset by other factors, such as productivity gains—a phenomenon which is playing out in spades right now. Further, high unemployment and low capacity utilization prove there's enough slack in the system to keep inflation at bay for now. The cost of labor should remain competitive for awhile yet, and producers will likely seek to boost profits through increased production, not higher prices. These factors provide the Fed plenty of time to plan its monetary exit strategy before inflation accelerates out of control.


Most importantly, inflation isn't necessarily a good reason to abandon stocks—equities have historically tended to outperform bonds and cash during inflationary environments.


Q: Will QE2 dethrone the dollar as the global reserve currency?


A: The world won't abandon the dollar because there's nowhere else to go.


According to some rhetoric, QE2 will dethrone the dollar as a reserve currency and foreign investors will stop lending to the US government en masse. But where will these investors put their money instead? Japan has a stagnant economy and close to the highest debt levels in the developed world. Europe is dealing with a sovereign debt crisis and severe fiscal imbalances. China—the supposed "heir apparent" to US economic supremacy—doesn't even let its currency circulate outside its borders.


Ultimately, the safety, depth, and liquidity of US capital markets remain unparalleled, and if some unexpected event did cause another financial panic, investors would likely do what they did during the last financial panic: flock to the dollar.


Q: Is QE2 devaluing the dollar against foreign currencies?  


A: The dollar may weaken against some foreign currencies, but QE2 won't be the prime culprit.


Some foreign leaders believe QE2 will devalue the dollar. Exchange rates are prices, and like all prices they are determined by supply and demand. Increase the supply of dollars, and all else equal, their price in other currencies (i.e., exchange rate) will decrease. But an increase in the US money supply isn't likely the most significant determining factor in global currency markets. If spread equally in daily increments over six months, the daily value of QE2 would account for only about 0.1% of the volume of global dollar exchange.


Factors on the demand side of the equation are much more important. Where currencies are appreciating against the dollar, it's primarily because they have stronger economic growth prospects, offer higher interest rates, and/or have trade surpluses—all factors which can be powerful currency demand drivers. For example, Brazilian policymakers have blamed US monetary policy for a rising real. But with 7% expected economic growth this year, overnight interest rates near 10%, and booming commodity exports, an appreciating Brazilian real shouldn't be a surprise.


Q: Will the Fed spark a "global currency war?"


A: It's a risk, but improbable. More likely, global currency markets will face diminishing government intervention in the years ahead.    


Some economists worry about the impact of QE2 on global trade relations. If the dollar weakens against foreign currencies, this could make US exports more attractive to foreign buyers, while making foreign exports less attractive to US consumers—theoretically shifting economic activity to the US at the expense of its trading partners. Should governments feel their economic competitiveness is being eroded by QE2, they may counter with foreign exchange intervention, capital controls, or even outright, old-fashioned trade protectionism. This would be bearish for stock market investors—the global economy is much more efficient when trade, currency, and capital are unrestricted by government policy.


However, it's improbable any country starts a trade war over QE2. The countries that have been most vociferous in their rhetoric against QE2 (e.g., Brazil, China, Germany, South Korea) also (not so coincidentally) happen to be those that are most dependent on export trade to fuel economic growth. A global currency war—or a trade war—would have a crushing effect on these economies and wouldn't benefit their relative position within the world. The power of self-interest should thus serve as a powerful bulwark against global protectionism.


Perhaps more importantly, many countries actually have much to gain from domestic currency appreciation—particularly those who have artificially fixed the value of their currency through foreign exchange intervention, such as China. The strengthening of an undervalued currency can bolster domestic purchasing power, reduce over-reliance on exports, provide more control over monetary policy, and slow the rate of imported price inflation. These are powerful incentives to let market forces determine exchange rates and should ultimately lead to less currency intervention, making markets freer and more efficient—an unequivocally bullish driver for the global stock market.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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