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.

Interesting readings on Economics Nobel Prize

The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 to

1. Eugene F. Fama
2. Lars Peter Hansen
3. Robert J. Shiller

Trendspotting in asset markets:
There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

Nobel Prize winners say markets are irrational, yet efficient
Are stock markets irrational, driven by greed and fear, subject to euphoria and panic? Or are they highly efficient indicators of intrinsic value? Both, says the Nobel Prize Comittee for Economics, with no sense of contradiction.

The economics Nobel matters for India
The recent announcement of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has gone to three extremely deserving recipients. The combination of deep economic insight and clever methodological contributions that Eugene Fama, Lars Hansen and Robert Shiller have brought to this field has revolutionized our understanding of the determinants of asset prices.

Split Nobel prize shows bubbles are worth watching
Economics is the only field in which two people can share a Nobel prize for saying opposing things.

Economists Clash on Theory, but Will Still Share the Nobel

Nobel Prize U.S. winner warns of 'bubbly' global home prices

Fama, Shiller, Hansen Win Nobel Prize for Asset-Price Work

Bubbles & Crashes - 2

Sorry guys I didn't continue immediately after the 1st episode as I got much more important news(Repo rate cut and PM's Speech) than this. So here we go...

The Crash of 1987

When: October 19, 1987
Where: USA
Effect: 508.32 points, 22.6%, or $500 billion lost in one day, the largest one-day percentage drop in history. By the end of October, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover.
Main reasons for the crash are…

1. DERIVATIVE SECURITIES

Initial blame for the 1987 crash centered on the interplay between stock markets and index options and futures markets. The Brady Commission concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash.

2. COMPUTER TRADING

Many analysts blame the use of computer trading by large institutional investing companies. Computers were programmed to automatically order large stock trades when certain market trends prevailed.

3. ILLIQUIDITY

During the Crash, trading mechanisms in financial markets were not able to deal with such a large flow of sell orders. Many common stocks in the New York Stock Exchange were not traded until late in the morning of October 19 because the specialists could not find enough buyers to purchase the amount of stocks that sellers wanted to get rid of at certain prices.

4. U.S. TRADE AND BUDGET DEFICITS

Another important trigger in the market crash was the announcement of a large U.S. trade deficit on October 14, which led Treasury Secretary James Baker to suggest the need for a fall in the dollar on foreign exchange markets. Fears of a lower dollar led foreigners to pull out of dollar-denominated assets, causing a sharp rise in interest rates.

5. INVESTING IN BONDS AS AN ATTRACTIVE ALTERNATIVE
Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% [the summer before the crash]. This offered a lucrative alternative to stocks for investors looking for yield.

6. OVERVALUATION

Many analysts agree that stock prices were overvalued in September, 1987. Price/Earning ratio and Price/Dividend ratios were too high [Historically, the P/E ratio is about 15 to 1; in October 1987 the P/E for the S&P 500 had raised to about 20 to 1].


The Asian Crisis

When: 1989 - 2003
Where: Southeast Asia but primarily Japan
Effect: Percentage Lost From Peak to Bottom: 63.5% as of 2003
The Japanese economy gained extreme strength after its long recovery from the war and the atomic bombs. Japan became unstoppable economic force by coupling with the other emerging Southeast Asian economies.

Between 1955 and 1990, land prices in Japan appreciated by 70 times and stocks increased 100 times over. Trading became the national sport, and the Japanese jumped into the market with more blind confidence than that of the Americans of the 1920s. During the eighties, large Tokyo firms were worth more individually than all their American counterparts combined, and Japanese golf courses were worth more than the value of all the stocks on the Australian exchange.

An inverted growth cycle perpetuated itself when landowning firms started using the book value of their land to buy stocks that they in turn used to finance the purchase of American assets. Like the prosperity of the Roman Empire, the prosperity of Japan proved to be its undoing as corruption began to spread throughout the political and business realms.

The government sought to excise the tumor and put a halt to the inflammatory growth of stocks and real estate by raising interest rates. Regrettably, this didn't have the slow soothing effect on the market that the government hoped. Instead, it plunged the Nikkei index down more than 30000 points.

East Asian Currency Crisis

When: 1997
Where: East Asian Countries like Thailand, Malaysia, Singapore and Philippines

In addition to above mentioned Japanese crisis, East Asian Currency started in that period only. And in September I have posted about this. For your reference I will provide the gist of that posting here.

The crisis first came out into the open in Thailand where doubts about sustainability of the exchange rate peg (to a basket dominated by the US dollar) prompted a run on the currency in mid-May 1997. There were significant spillover effects on other countries in the region, notably Indonesia, Malaysia, and the Philippines. The Thai baht and the Philippine peso came under renewed pressure in late June 1997 and early July 1997, leading authorities to abandon their respective pegs in early July. The baht had lost around 16 percent against the US dollar in a single day on July 2, 1997. This unleashed a flurry of speculative activity in other ASEAN currencies.

Between end June 1997 and end March 1998, depreciation of these currencies vis-à-vis US dollar ranged between 11% and 74%: Indonesian Rupiah (74%), Thailand baht (37%), Malaysian ringgit (31%), Philippine peso (33%), South Korean won (36%), and Singapore dollar (11%).

Investor confidence declined leading to sharp declines in equity prices in the stock markets of these countries. Compared with June 1997, the stock prices in January 1998 had declined in the range of 32 per cent (in Thailand) to 53 per cent (in Malaysia).
Causes are:

1. The prolonged maintenance of pegged exchange rates, in some cases at unsustainable levels, which complicated the response of monetary policies to overheating pressures and which came to be seen as implicit guarantees of exchange value, encouraging external borrowing and leading to excessive exposure to foreign exchange risk in both the financial and corporate sectors.

2. Debt overhangs. In Malaysia, loans are 140 percent of annual economic output -- the highest in Asia. Many loans are for real estate speculation or consumption; only 16 percent are for manufacturing. Thailand needs to shut, merge or fix 58 troubled financial institutions.

3. Inflated values. Japan's economy has been in recession since real estate and stocks collapsed in 1990. The Nikkei has never risen above 58 percent of its 1989 high.

4. Loose financial practices. In South Korea, foreign currency reserves have been pledged to guarantee foreign loans to corporate borrowers that push exports. In Thailand, Malaysia and Indonesia, off-the-book government guarantees cause bank loans to flow toward favored companies that create jobs and drive exports.

5. Imprudent lending by international lenders.

6. High and unsustainable level of current account deficit.

For further information you can check my September’s posts…


The Dotcom Crash

When: March 11, 2000 to October 9, 2002.
Where: Silicon Valley (for the most part)
Effect: NASDAQ Composite lost 78% of its value as it fell from 5046.86 to 1114.11.

The "dot-com bubble" was a speculative bubble during which stock markets in Western nations saw their value increase rapidly from growth in the new Internet sector and related fields. The period was marked by the founding of a group of new Internet-based companies commonly referred to as dot-coms. A combination of rapidly increasing stock prices, individual speculation in stocks, and widely available venture capital created an exuberant environment in which many of these businesses dismissed standard business models, focusing on increasing market share at the expense of the bottom line.

The dot-com model was inherently flawed: a vast number of companies all had the same business plan of monopolizing their respective sectors through network effects, and it was clear that even if the plan was sound, there could only be at most one network-effects winner in each sector, and therefore that most companies with this business plan would fail. In fact, many sectors could not support even one company powered entirely by network effects.

In spite of this, however, a few company founders made vast fortunes when their companies were bought out at an early stage in the dot-com stock market bubble. These early successes made the bubble even more buoyant. An unprecedented amount of personal investing occurred during the boom.

One possible cause for the collapse of the NASDAQ (and all dotcoms) were massive, multi-billion dollar sell orders for major bellwether high tech stocks that happened by chance to be processed simultaneously on the Monday morning following the March 10 weekend. This selling resulted in the NASDAQ opening roughly four percentage points lower on Monday March 13 from 5,038 to 4,879—the greatest percentage 'pre-market' sell off for the entire year.

Another reason may have been accelerated business spending in preparation for the Y2K switchover. Once New Year had passed without incident, businesses found themselves with all the equipment they needed for some time, and business spending quickly declined.

The first shots through this bubble came from the companies themselves: many reported huge losses and some folded outright within months of their offering. Siliconaires were moving out of $4 million estates and back to the room above their parents' garage. In the year 1999, there were 457 IPOs, most of which were internet and technology related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In 2001 the number of IPOs dwindled to 76, and none of them doubled on the first day of trading.

Subprime+ Credit Crunch

When: We are going through that now.
Where: Base is in US and spreading to everywhere.
Effect: Yet to find out as still there is long way to go.

Guys you all know that what Subprime crisis is, where it is started and how it is affecting everybody. So I will directly mention the some of the causes for that briefly as I need to close this topic as this is becoming very lengthy to read. So here are the causes:

1. Boom and bust in the housing market

2. Speculation

3. High-risk mortgage loans and lending practices

4. Securitization practices

5. Inaccurate credit ratings

6. Government policies

7. Financial institution debt levels or leverage


Sources...

Investopedia
Wikipedia &
Google(last resort)...

Bubbles & Crashes - 1

Now each and every person is thinking global financial turmoil. Everybody is asking same questions!!! What is happening in United States of America, European Countries & their impact to Asian countries including India? Why it happened? When it is going to end? So guys today I am talking about what are these turmoils or bubbles or whatever you call them? And how these happened in the history at various point of time and in different places? So here I am providing some information on bubble, crashes and some of the major crashes in the history.

A bubble occurs when investors put so much demand on a stock/commodity that they drive the price beyond any accurate reflection of its actual worth, which should be determined by the performance of the underlying company.

Investing in bubbles often appears as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.

A crash is a significant drop in the total value of a market, attributable to the popping of a bubble, creating a situation wherein the majority of investors are trying to flee the market at the same time and consequently incurring massive losses.

Attempting to avoid more losses, investors during a crash start panic selling, hoping to unload their declining stocks onto other investors. This panic selling contributes to the declining market, which eventually crashes and affects everyone. Typically crashes in the stock market have been followed by a depression. Thicker the bubble, harder will be crash.

It is important to note the distinction between a crash and a correction. A correction is supposedly the market's way of slapping some sense into overly enthusiastic investors. As a general rule, a correction should not exceed a 20% loss of value in the market. Surprisingly, some crashes have been erroneously labeled as corrections, but a "correction," however, should not be labeled as such until the steep drop has halted within a reasonable period.

The Tulip and Bulb Craze

When: 1634-1637
Where: Holland
Effect: At the peak of the market, a person could trade a single tulip for an entire estate, and, at the bottom, one tulip was the price of a common onion.

In this period contract prices for the newly-introduced tulip (due to virus attack, the color on the petals changed and because of this demand for the same drastically rallied) reached extraordinarily high levels and then suddenly collapsed. At the peak of tulip mania in February 1637 tulip contracts sold for more than 20 times the annual income of a skilled craftsman. It is generally considered the first recorded speculative bubble. The term "tulip mania" is often used metaphorically to refer to any large economic bubble.


The South Sea Bubble

When: 1711
Where: United Kingdom
Effect: Stocks in the South Sea Company were traded for 1,000 British pounds (unadjusted for inflation) and then were reduced to nothing by 1720. Massive amount of money was lost.

The mania started in 1711, after a war which left Britain in debt by 10 million pounds. Britain proposed a deal to the South Sea Company, where Britain’s debt would be financed in return for 6% interest. Britain added another benefit to sweeten the deal: exclusive trading rights in the South Seas. The South Sea Company issued stock to finance operations and gain investors. Shares were quickly snatched up from the start. The South Sea Company, seeing the success of the first issue of shares, quickly issued even more. This stock was rapidly consumed by the voracious appetite of the investors.

Eventually the management team took a step back and realized that the value of their personal shares in no way reflected the actual value of the company or its dismal earnings. So they sold their stocks in the summer of 1720 and hoped no one would leak the failure of the company to the other shareholders. Like all bad news, however, the knowledge of the actions of management spread, and the panic selling of worthless certificates ensued. The huge hole in the south sea bubble also punctured the unrealistic value and came crashing down.


The Florida Real Estate Craze

When: 1926
Where: Florida
Effect: Land that could be bought for $800,000 could, within a year, be resold for $4 million before crashing back down to pre-boom levels.

The 1920’s, in America, were a time of great prosperity. Florida became hotspot for tourism land prices started sky rocketing. Many astute investors took notice and started buying Florida real estate. The population in Florida was growing exponentially and housing couldn’t meet the demand. At this point, almost anybody could invest in Florida, even without much money. Credit was plentiful and soon everybody in Florida was either a real estate investor or a real estate agent.

Land prices quadrupled in less than a year and eventually, however, there were no "greater fools" to buy the disgustingly overpriced land, and prices began to adjust. Speculators realized there is a limit to the boom, and began to sell their properties to solidify their profits while they could and panic selling started. With thousands of sellers and very few buyers, prices came down with a sickening thud, twitched a bit, and then crawled down even lower.


The Great Depression (1929)
When: October 21, 24 and 29, 1929
Where: USA
Effect: More than 40% drop in the market from the beginning of September 1929 to the end of October 1929. In fact, the market continued to decline until July 1932 when it bottomed out, down nearly 90% from its 1929 highs.

So the reasons for the Great Depressions are…

1. Stock Market Crash of 1929

Many believe erroneously that the stock market crash that occurred on Black Tuesday, October 29, 1929 is one and the same with the Great Depression. In fact, it was one of the major causes that led to the Great Depression. Two months after the original crash in October, stockholders had lost more than $40 billion dollars.

2. Bank Failures

Throughout the 1930s over 9,000 banks failed. Bank deposits were uninsured and thus as banks failed people simply lost their savings. Surviving banks, unsure of the economic situation and concerned for their own survival stopped giving new loans. This exasperated the situation leading to less and less expenditures.

3. Reduction in Purchasing Across the Board

With the stock market crash and the fears of further economic woes, individuals from all classes stopped purchasing items. This then led to a reduction in the number of items produced and thus a reduction in the workforce.

4. American Economic Policy with Europe

As businesses began failing, the government created the Hawley-Smoot Tariff in 1930 to help protect American companies. This charged a high tax for imports thereby leading to less trade between America and foreign countries along with some economic retaliation.

5. Drought Conditions

While not a direct cause of the Great Depression, the drought that occurred in the Mississippi Valley in 1930 was of such proportions that many could not even pay their taxes or other debts and had to sell their farms for no profit to themselves.


Will be continued...