Effectiveness of Quantitative Easing (QE)

Last week, October 29, 2014, the U.S. Federal Reserve (Fed) concluded its $4 trillion QE programs   saying "there has been a substantial improvement in the outlook for the labor market" and "there is sufficient underlying strength in the broader economy". Many economists’ opinions on QE are divided,  some arguing in favor of it and some against it. Let’s have a look at the things, how they unfolded…

How it all started?

It all started with 2007-2008 financial crisis, to avert the ripple effects of the crisis, Fed started with reducing its fed fund rate and ended up with pumping trillions of dollars of money through three QE programs. After New Century Financial Corporation, a leading subprime mortgage lender, filed for bankruptcy in April 2007, rating agencies became cautious and started downgrading subprime mortgage bonds. Looking at the financial markets’ nervousness and to maintain the liquidity in the system, Fed started with 50 basis points cut in fed fund rate to 4.75% in September 2007 and by April 2008 fed fund rate touched 2%. Within 8 months, Fed reduced its interest rates by 325 basis points.

On September 7, 2008, the Treasury department took control of mortgage giants Fannie Mae and Freddie Mac and pledged a $200 billion cash injection to help the companies cope with mortgage default losses.

World financial markets spooked on September 15, 2008, when Lehman Brothers filed for Chapter 11 bankruptcy protection. As result of Lehman collapse, global money market immediately dried up, equity markets routed like there is no tomorrow, bonds and dollar skyrocketed. After seeing this, U.S. government, Treasury department and Fed took various measures to calm the financial markets.

Immediately after Lehman collapse, Fed and the U.S. government helped the one of the world’s largest insurer, AIG with $85 billion. In other words, AIG was bailed out by Fed and the U.S. government.

Within matter of three months, Fed reduced fed fund rate by more than 175 basis points to keep it between 0 to 25 points in December 2008. In between, when fed fund rate was about reach near zero levels, Fed started realizing the liquidity trap problem in traditional monetary approach. Ben Bernanke at helm of the Fed, who extensively studied Japanese lost decade and 1930s the great depression, started thinking of unconventional ways to pump the money into the economy.

QE1, QE2 and QE3

QE1 began in November 2008, with Fed deciding to buy $500 billion worth of mortgage backed securities (MBS) from financial market participants, $100 billion worth of debt obligation mortgage buying from giants Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. Fed did extend another $100 billion to Fannie Mae, Freddie Mac and Fed also announced the purchase of another $300 billion worth of long term treasuries. When QE1 ended in first quarter of 2010, Fed almost spent about $100 billion every month on buying mortgage backed securities for 17 months. That means, Fed was sitting up on about $1.7 trillion worth of mortgage backed securities. Overall QE1 can be classified as bailout fund.

In November 2010, Fed restarted its unconventional monetary policy, QE2, with $600 billion worth of long term treasuries buying plan. Fed expected to keep long term treasury rates and interest rates to be lower to speed start the economic activity. As previously announced, Fed concluded its $600 billion bond purchasing program in June 2011. QE2 can be termed as the fund used to kick-start the economic recovery.

In September 2011, Fed came up with yet another program called operation twist, wherein Fed started selling short term treasury bills and notes, and buying long term treasury bonds, to lower the long term treasury yields. Total fund allocated for this program was $400 billion. This showed that Bernanke was shifting the central bank's focus from repairing the damage from the subprime mortgage crisis to supporting lending in general.

In September 2012, Fed announced QE3. It agreed to buy $40 billion in MBS, and continue Operation Twist, adding a total $85 billion of liquidity a month. In December 2012, Fed announced it would buy a total of $85 billion of long-term treasuries and MBS put together. It clarified its direction by promising to keep it until one of two conditions was met: either unemployment rate to fall below 6.5% or inflation rose about 2.0%.

Did QEs Work?

In hindsight it’s always easy to analyze things! But talking about whether Fed’s QEs worked or not, it is somewhat complicated to question to answer and those answers are divided. But many economists agree that Fed accomplished couple of its goals. It’s unimaginable to know what would have happened without Fed's QEs. In the beginning, Fed wanted to stop the financial crisis from getting worse. By buying mortgage securities, Fed prevented more banks from failing and eased the frozen lending and money markets. Also being far more proactive and expansionary in nature of Fed as compared to ECB of European region reflects in the present status of both the regions. Fed helped to stabilize the U.S. economy, providing the funds and the confidence to pull out of the recession.

But whether QEs achieved what they were intended to achieve? Whether they succeeded in creating more jobs, spurring up the economy, boosting the inflation to Fed expectation level? I think answer would be “No”.  

Why QEs didn’t create enough jobs or reduce unemployment rate to Fed’s normal acceptance level of 5%. Why unemployment rate, which rose to 10% in 2009 till today didn’t reduced to before the crisis level of 5%, even after six non-stop years money pumping from Fed. Because monetary policies can't do much to reduce unemployment as liquidity is not the problem. In other words, there is little that expansionary monetary policies can do to increase the job creation.

High unemployment rate is due to two factors: cyclical unemployment and structural unemployment. Cyclical unemployment is caused by the economic downturns and structural unemployment happens when the long-term unemployed people lose their skills, needed to compete in the job market. Even now many economists argue that, present decline in unemployment rate is substantially because of long-term unemployed people quitting the job searching process, which is reducing unemployment rate.

QE didn't achieve Fed's goal of making more credit available and boosting the inflation. It gave the money to banks, which basically sat on the funds instead of lending it out. Though Fed succeeded in lowering the cost for banks to make mortgages, the banks didn’t actually start making more mortgages. Since banks didn't lend out the money, inflation wasn't created in consumer goods. As a result, Fed's measurement of inflation, the CPI, stayed below Fed's target.

However, QE did create an asset bubble kind of situation, first in gold and other commodities, and then in stocks.  An gold price more than doubled, rising from $869.75/ounce in 2008 to $1,895/ounce in 2011. Oil prices more than tripled from around $40/barrel in 2008 to around $120/barrel in 2011. After that, investors shifted to stocks. S&P 500 more than doubled from 700 levels in 2009 to 2000 levels in 2014.

QE could have been better designed. There could have been a better balancing act between monetary and fiscal policies. In retrospect far too much faith was put in the banks to channel the money to where it was needed. Edward Hadas of Reuters Breakingviews once nicely said, QE could have been worse, and it should have been better.

Bond markets dictate Fed policy!

U.S. Federal Reserve chairman Ben Bernanke in his press conference after FOMC meeting on September 18 said “we can't let market expectations dictate our policy actions”, when asked about Fed tapering. But Federal Reserve did exactly let bond markets to dictate or reverse their policy guidance communication.

From last 4 months Fed wanted to prepare markets for the reduction in bond buying program. Various governors irrespective of their dovish or hawkish stance, they talked about either for or against tapering of bond buying. They communicated and convinced markets that Fed is expected to announce tapering of the bond buying in September meeting by $10 billion as per overall consensus in the markets.

When Fed started talking about tapering Benchmark bond yield started soaring and reached peak of 2.9% recently. Before tapering news hit the markets, Benchmark 10 year bond yields were around 1.6% in early May of this year. They jumped 130 basis points as heavy sell off in treasuries incurred. 30 year U.S. mortgage rates jumped to 4.2% from 2.8% around 50% jump! Markets started filtering in the news of Fed tapering.

After yesterday's FOMC meeting, in its press release, Fed said, “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.” In last 4 FOMC statements, Fed used almost same language “the committee sees the downside risk to the outlook of the economy”. Where as in this meeting it talked about concerns over financial tightening conditions in recent months!

In fact recent surge in bond yields is caused by Bernanke and his colleagues’ talk of tapering. They communicated their policy guidance as usually all central banks try to maintain the transparency in their policy guidance communication and their thought process.

Actually short term money markets eased in this span of 4-5 months. Below is the table in which all indicators indicate short term borrowing rates eased in all category.

Money market indicator	May 1, 2013	September 17, 2013	Change
2 week repo	0.17%	0.08%	-52%
3 month repo	0.16%	0.08%	-50%
2 week mortgage repo	0.21%	0.10%	-52%
3 month mortgage repo	0.20%	0.13%	-35%
Fed fund rate	0.15%	0.09%	-40%

Here question is not about whether economy started recovering or started creating enough jobs; it’s about how the world’s biggest central bank failed in judging economic scenario and failed in their communication. Many referred it as “surprise”, I would like to call it call as shocking. Surprises can be like Paul Volcker doubling Fed fund rates from 10% to 20% between 1979 and 1981 to tame the inflation. But not this one, where Fed prepared the markets for tapering and in turn markets convinced Fed not to taper!

Bernanke may be worried about Greenspan legacy!

According to various polls and forecasts U.S. Federal Reserve Chairman Ben Bernanke is expected to announce scaling back the monetary stimulus in the FOMC meeting (17th &18^th September). As per consensus Fed is expected to cut down its monthly bond buying program by $10 billion from present $85 billion (Fed is buying $45 billion government bonds and $40 billion mortgage securities per month to stimulate the economy).

When Bernanke spoke about tapering down of bond buying program first time in May, 2013 global markets reacted very sharply. U.S. bond yields soared, emerging countries’ bond, stock and currency markets sold off heavily and some counties' (Brazil and Indonesia) Central banks raised interest rates to prevent outflow. Aftermath of the global markets volatility, analysts started discussing timing and quantity of Fed tapering, whether American economy produced enough employment, whether economy recovered from the crisis, if yes then is this recovery sustainable?

But Bernanke may not be worried about timing (September or December) of tapering or quantity of tapering but the way markets are expecting and perceiving the quantitative easing (QE)! He may be worried about QE boosting asset prices than real economy going ahead. He may be worried about market expectations of low interest rate for too long. He may be worried about continuing his policies in his name after his exit from Fed Chair in January 2014. He may be worried about how history is going to see him, the one who saved the world from the great recession or the one who lead the world from the great recession to one more crisis!

Alan Greenspan, Bernanke’s predecessor lowered American interest rates after dot com bubble burst and 9/11 attack. Analysts criticise him for leaving interest rates too low for too long time, which was one of the reason for housing boom during early 2000. By the time Greenspan left Fed Chair (January 2006) American economy was at the edge of new crisis. Housing prices skyrocketed and it was too late for regulation and monitoring the situation as complex derivatives products dragged investments banks, insurance companies, banks, broking firms and rating agencies into the sector leading to economic crisis. So critics say Greenspan lead America from one crisis to another crisis!

Bernanke, whose term is ending in January 2014, may not want to repeat the Greenspan legacy! He may want to communicate to markets that stimulus shouldn't be taken for granted. He may be suggesting real economy benefitted sufficiently from quantitative easing or monetary stimulus has reached its limits to boost the economy and beyond this there might be bubble formation! He may want to leave the office with a note to historians stating that he started it (QEs) but he also tried to end it!

Rupee is what rupee does!

Exactly, headline is derived from economic definition of money, "money is what money does", which is applicable to Rupee too. As per economic definition, value of Rupee is determined by its purchasing power parity (PPP) compared to international standards. But is this definition holds true in this turmoil markets? I don't think so.

In recent days Rupee depreciation or speed of depreciation has not only become big issue domestically but also international commentators are expressing their opinions. There are various research reports available in markets now on Rupee’s next target. Some brokerage houses are predicting it will touch 70+ against Dollar and some are telling it will go back to 60/Dollar. Now everybody is watching whether Rupee will touch 70 before 60 or 60 before 70.

Most of us by now know the macroeconomic issues India is facing due to which currency is moving in this fashion. But here I am trying figure out how things change in the micro level or ground level.

Till early May of this year currency wasn’t our big news or concern, analysts were thinking about macro issues like current account deficit, fiscal deficit, inflation, RBI’s stance on monetary policy and etc. By this logic nothing substantial happened on macro front, which wasn’t priced in the market at that time.

But in May U.S. Federal Reserve chairman Ben Bernanke first time talked about scaling back the monetary stimulus (Fed is buying $85 billion worth of bonds every month) because of moderate growth in U.S. economy. Immediately after his statement bond markets reacted very sharply and bond yields started spiking. At that time U.S. Benchmark 10 year bond yields where trading roughly around 1.6% and Indian benchmark yields where around 8% as shown in the below two graphs.

Investors were coming to India as there was arbitrage opportunity or interest rate parity due to yield spread between the two countries. Even after incurring currency hedging cost of around 6% foreign investors were making 2% (8% bond yield – 6% currency hedging cost) risk free return.

But once U.S. bond yield crossed that crucial 2% level investors thought investing in U.S. bonds is more profitable than investing in India with less risk. So funds from bond market started flowing out of India and till now roughly $4 billion went out of India according to one estimate.

At the same time U.S. stock markets started regaining their historical highs and were touching new highs due to which money from equity markets also started changing hands. Because of outward movement of money Dollar demand increased and Rupee started depreciating as shown in the third graph. But after initial sell-off in the currency market, sentiments drove the markets with more speed and quantity leading to panicking situation making policy makers nervous! Policy makers did take some half hearted measures and did not convince the markets either through their communication or from their actions leading to rout in the markets!

After this heavy sell-off Finance Minister and some analysts are saying Rupee is undervalued due to overshooting of currency markets. One of the popular indexes to measure the valuation of the currency is Big Mac Index. It gives a rough picture of how a country’s currency is trading in real exchange terms or purchasing power parity. It compares cost of Big Mac of McDonalds in U.S. with other countries.

McDonalds’ Big Mac not sold in India since beef is not common; but it is replaced by Maharaja Mac made up of Chicken. As per latest available data cost of Big Mac in U.S. is $4.56 and Maharaja Mac in India is Rs. 100. So PPP of India is 21.93 (100/4.56). According to Big Mac Index Indian Rupee is undervalued 68% [(21.93 – 67.5)/67.5]. Here I have taken 67.5 as exchange rate of Rupee. Indian currency is the most undervalued currency as per Big Mac Index. 

Do policy makers have any other option?

After recent Federal Reserve meeting, when Chairman Ben Bernanke’s commented about tapering of bond buying program, global financial markets have become very volatile. U.S. benchmark 10 year treasury yields touched 2.8% recently from 1.6% in early May. Hot money started flowing out of emerging markets (EM) following some kind of theme like sell EMs and buy U.S.!

As a result of this majority of emerging countries’ stock and bonds sold-off, currencies started depreciating. Being part of globalized world now, India too is going through all these market phases. Apart from global issues, India has its own problems like large current account deficit, corruption and scandals, policy paralysis making it as non-favorable destination for investment at least for now. Indian growth, measured in terms of GDP, slowed to 5% levels from above 9% levels, Industrial Production data is not showing recovery signs, Consumer Inflation still very high and whole price inflation started inching up again; currency depreciated more than 12% in 12 weeks. 

Indian central bank, RBI is under pressure to support the growth, curtail depreciation of Rupee, monitor the capital flows and has to maintain its independence. RBI is exactly in “impossible trinity”.  

Consequently government and RBI took several measures to curb the currency depreciation and capital flight from India, like hiking gold import duty couple of time, banning importing of bullion coins and medallions, asking gold importers to keep 20% of total imported gold for exports and exports-purpose, domestic liquidity tightening, reducing the limit for Overseas Direct Investment (it’s like Indian FDI abroad) from 400% of the net worth to 100% and so on.

Many commentators are now criticizing these recent policy moves and intervention in market. It’s not the question of either supporting or opposing them, whether policy makers have any other option which will help them in near term? Of course there should not be any second thought on long term plans to correct the fundamentals; but what about immediate future as Keynes famously said “In the long run we are all dead”. 

This brings back the old question, whether markets are efficient or in other terms does efficient market hypothesis holds true? Going by Keynesian concepts and economic boom and bust cycles it does appear like markets need an invisible-hand to guide them and calm the nerves. But that again depends on how big that invisible-hand is, how far it is non-conventional in its approach and how much market is ready to listen to it and trust. Only time will tell!