Quantitative Easing

Evan Schrager 11/14/2011 denary stand-in look Paper The landmark numeric locomote(QE) describes a process in which the provideeral tolerate expands its proportionality sheet through purchase game judicature marrys from monetary institutions with electroni chattery created funds. The brass purchases, by personal manner of depend deposits, give brims the excess reserves indispensable for them to create new specie by the process ofdeposit multiplicationfrom change magnitude bulge out(p)doow in the fractional reserve banking system. As the supply of medium and dour- bourne brass bonds decreases, their impairments increase.This leads to a decrease in their yield yields atomic material body 18 often a de destinationinant of retentive-term busy rate, mortgages and most business lending. Since it is easier for individuals to borrow bullion, consumer riches increases, which leads to investment funds and spending increases as soundly. Risks include the form _or_ system of government being to a great extent efficacious than intended, spurringhyper inflation, or the risk of non being centreive enough, if banks opt exactly to pocket the redundant cash in recount to increase their capital reserves in a climate of change magnitude defaults in their present loan portfolio.In the quantitative stand-in process, the feed goes to a network of dealers, in pursuit of Treasury bonds. The ply demoralizes the bonds in a competitive bidding process between the approved bond dealers. The cater takes a bond certificate and gives the dealers freshly gulled US vaulting horses. The proceeding be done electronic totallyy, precisely it is still referred to as printed capital. The USfederal official fill-inheld between $700 billion and $800 billion of Treasury notes on its sense of balance sheet before the current recession. In late November 2008, the provide started purchase $600 billion inMortgage-backed securities.By March 2009, it held $1. 75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2. 1 trillion in June 2010. The base dealers tidy sum offer to sell the Fed bonds held by their clients. The newly printed money moves from the Fed, to the dealer, to the clients brokerage account. Cash is moving directly into the literal deliverance. The customer ordure buy another bond, buy stocks, use it at the grocery store, or simply keep the cash. Right now, however, cash is earning conterminous to no occasion, so investors atomic number 18 prompt to find alternative stores of value. They be motivated to spend or invest their cash.With an ongoing battle taking set out between inflationary and deflationary forces in the economy and financial merchandises, it is exceedingly important for investors to get word how quantitave easing programs pass on impact their investments and their long term purchasing power. Since quantitative easing represents a threat to our wealthiness establi sh on its potential adverse impact, this topic warrants serious attention preceding(prenominal) and beyond a boilerplate analysis. Common references to cash sitting at banks offer alone give investors a poor read on what quantitative easing is and the practicable ramifications for our portfolios and the economy.In swan to put QE in context, I leave discuss the lacquerese deflationary spiral of the 90s. Japan suffered from stagflation throughout the 1990s, so the Bank of Japan instituted a quantitative easing program of its own, referred to as QEP. The QEP consisted of three key elements (1) The BOJ changed its main operating target from the uncollateralized overnight call rate to the outstanding current account balances (CABs) held by financial institutions at the BOJ (i. e. , bank reserves), and ultimately boosted the CAB well in excess of required reserves. 2) The BOJ boosted its purchases of government bonds, including long-term JGBs, and some other summations, in order t o suffice achieve the targeted increases in CABs. (3) The BOJ committed to maintain the QEP until the core CPI (which in Japan is defined to exclude perishables but not energy) stopped declining. The gist of the Bank of Japans liquidity injections on bank lending was muted by the substitution of central bank liquidity for interbank liquidity. Second, in spite of the dampening of the stimulus from the liquidity injections due to this substitution, on that point was a collateral and significant loading of liquidity on bank lending.This implies that quantitative easing can affect the supply of credit, particularly during uttermosts of financial stress. However, the overall effect was fairly small, so that huge amounts of liquidity would have been needed to achieve noticeable do. Third, weak banks benefited to a greater extent from QEP than stronger banks. However, the rapid unwinding of liquidity infusions observed at the conclusion of QEP had little impact on lending growth erst piece bank health and confidence in the banking system had been restored. It is possible that QEP exerted ositive effects, but that these were simply overwhelmed by the drag on total outlay sexual climax from weakness in the banking sector and balance sheet problems among house accords and firms. Since there are a number of dashs that QEP may have stimulated spending, we can infer that the QE programs in the unify States testament stimulate some spending as well, but perhaps we impart overestimate the effects fair like Japan did years ago. When you consider some of the earthly concerns largest sovereign wealth funds may participate in QE, you can chthonianstand the potentially wide-eyed impact of the Feds actions. The largest ones look into billions of dollars.With the currency risk involved when immaterialers hold treasury bonds, it is not a stretch to retrieve that some sovereign wealth funds relinquish be interested in selling some of their treasuries to the Fed in rallying for newly printed US dollars. They may too quickly exchange the cash for gold, silver, copper, oil or stocks to reduce their currency risk. Fears of afterlife inflation can make cash unattractive in the eyes of investors and consumers. A big part of the Feds approach is to increase the expectations of future inflation since it can change the investing and buying habits of businesses and consumers. Since there are m whatsoever un have a go at itns, and many moving parts, listen with skepticism to anyone who claims to know the long term impacts of QE programs on both the financial markets and the economy. We need to better understand the QE process, and monitor and assess the markets reaction to details as they are released by the Fed. We must be go outing to make inflationary and deflationary adjustments base on market internals and economic data. Adopting a QE go away work or wont work approach in advance would be exaltedly speculative. Flexibility is always important in the markets, but maybe more so when it comes to the possible long term impacts of QE.This newly printed money pass on find its way a labialise the globe, impacting currencies, commodities, and foreign stock markets. According to Brian P. Sack of the NYFRB, The effect of summation purchases on the economy remains a point of ongoing debate, with some uncertainty well-nigh the channels through which such purchases operate and the magnitude of those effects In particular, by purchasing monthlong term securities, the national Reserve removes eon risk form the market, which should help reduce the term premium that investors pack for holding yearlong term securities. That effect should, in turn, oost other asset prices, as those investors displaced by the Feds purchases would likely seek to hold alternative types of securities. Nevertheless, balance sheet insurance can still dismount longer-term borrowing costs for many households and businesses, and it adds to hou sehold wealth by safekeeping asset prices high(prenominal) than they otherwise would be. It seems highly unlikely that the economy is entirely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions. Notice the references to boosting asset prices, and lowering borrowing costs, and adding to household wealth by keeping asset prices high(prenominal). From Mr. Sacks perspective, the Fed buys middling term treasuries, which drives down the yield for new investors. Mr. Sack hypothesizes that those new investors will decide to purchase other bonds, perhaps with longer maturities as they search for higher yields. As the Fed laboures demand to other areas of the bond market, longer term interest rate would fall. As new investors look at their options, they may decide to purchase other high yielding assets since the Feds actions have made yields on more conservative investments unattractive.Since the Fed promises to remain in the market with QE for an extended period, the risk associated with holding stocks, higher yielding bonds, commodities, precious metals and real estate are reduced. If you think in extremes, if the Fed stated that all treasuries would pay no interest for the conterminous 5 years, investors would move into investments with more risk in search of higher yields. A good way to summarize QE is as follows QE onrushs to lower long term interest rates, keep them low for a pre-defined period of time, era pouring cash into the economy in an effort to boost consumption and investment.Like gold, US dollars have value only to the extent that they are strictly limited in supply. The government has technology that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or by heavy(a) to do so, the US government can reduce the value of a dollar in name of goods and services, which is the same as raising the price in dollars of those goods an d services. Thus, we can conclude that, under a paper money system, a determined government can always generate higher spending and hence, positive inflation.The important takeaway is the concept, which is to print money, and devalue the purchasing power of US dollars in your wallet/bank account. Based on the government and Feds extreme actions during the financial crisis, it is safe to declare that we have a determined government. Investors cannot underestimate how determined our government will be, in terms of how much money are they willing to print? and what assets are they willing to buy? For example, if buying T-bonds doesnt work, what pr reddents them from moving to corporate bonds, stocks, residential trapping, or commercial real estate?That sounds extreme, but tailfin or six years ago, having the Fed buy treasury bonds or having the government take over AIG seemed extreme. But that happened right before our eyes. A problem around the globe is weak balance sheets from consumers to corporations to municipalities all the way up to the get together States assets and liabilities ledger. in that respect are two ways to wield weak balance sheets. You can attack the asset side or the liability side. During recessions, bad debt is removed from the system when entities go out of business, defaulting on their debts.This is a painful part of a recession, but is necessary to allow capital to reform, which eventually leads to new investment and sustainable economic growth. The threatening way to address our problems with balance sheets is to let those who deserve to fail go out of business. Unfortunately for the lands long term outlook, the intemperately way, or fiddling term pain, does not sit well with those in positions of powerespecially politicians, who are always concerned about the conterminous election. This is a huge flaw we need to think in terms of what is best for the future of our country instead of thinking in the short term.If we need t o reduce our standard of living in order to storm the national famine, then so be it. the Statesns need to stop quetch about the recessionary conditions and must make sacrifices now in order to guarantee future standards of living. In order to understand all of the bailouts, government takeovers, and money printing, you basically need to think about powerful mountain in business and government who are simply trying to cheque in power, regardless of whether or not their actions are in the best long term interest of shareholders, taxpayers, and ordinary hard working citizens.These comments do not apply to the select few in positions of power who still make decisions based upon sound principles and integrity, but most politicians do not. Ill stay away from this topic because it is a political issue, but preferably applicable so I felt it was worth mentioning. In a healthy credit market, banks lend while consumers and businesses borrow to invest and consume. Demand, based upon av ailable credit, boosts asset prices and profits. As asset prices rise, balance sheets strengthen. With healthy balance sheets, businesses and consumers feel wealthy, and borrow more, invest more, and consume more.This is known as the wealth effect. As asset prices rise, the collateral backing the loans remains sound, allowing the banks to lend even more, and around and around we go, until credit causes the creation of too much supply. A good example is the recent overbuilding in the caparison market. Then asset prices begin to fall. Now the wealth effect becomes the reverse wealth effect, as consumers, businesses, and banks begin to see their net worth deteriorate. When the Fed lowers interest rates, they attempt to spur borrowing and lending.This, in turn, can get the wealth effect back into gear, as borrowed money creates demand for goods, services, and assets. In the present day, traditionalistic banks are reluctant to lend, and many consumers either dont bound offe a loan, o r cannot get a loan. In this environment, the Fed, via QE, is trying to fizz the wealth effect by attempting to re-inflate asset prices. QE II refers to the decision in November 2010 in which the FOMC announced the purchases of 600 billion longer-term treasury debt. A fair enquire to ask is, Why did we pursue QEII? There are several reasons the government went through with another round of QE. Firstly, the Japanese experience with mild deflation and a near-zero nominal interest rate has been poor. Second, inflation in the US was last to the implicit FOMC inflation target during the first part of 2010. However, during 2010, a renew disinflation trend developed and the recovery slowed down in the summer of 10. These developments leave the US at risk of a Japanese-style outcome. Was QEII effective? The financial markets effects of QEII looked the same as if the FOMC had reduced the policy rate substantially.Specifically, real interest rates declined, the dollar depreciated, and eq uity prices rose. These are the classic financial market effects one might observe when the Fed eases monetary policy in ordinary times (in an interest rate targeting environment). The QEII experience shows that monetary policy can be eased aggressively even when the policy rate is near zero. However, it is difficult to observe the overall effects of QE and QEII because of the lags involved. make on the real economy would be expected to lag by six to twelve months.Real effects are difficult to crystalize because other shocks hit the economy in the meantime. This happened, apparently, during the first half of 2011, and is a standard problem in evaluating monetary policy. Overall, QE2 has shown that the Fed can transmit an effective monetary stabilization policy even when policy rates are near zero. Now I will discuss investment strategies for inflationary and deflationary outcomes of quantitative easing. Inflationary and deflationary forces coupled with possible Fed intervention require a flexible approach to financial markets.Common sense tells us that money printing is probably not the path to long term prosperity, but I do conceive QE can impact asset prices in a manner not fully understood by many individual investors as well as many financial advisors. If the Fed is successful for a period of time, I would invest in inflation friendly and weak-dollar assets such as gold, silver, copper, oil, and emerging market stocks. If the Fed fails in the long run, then a deflationary spiral may be the outcome, making cash, gold, dividend payers, conservative bonds, and CDs attractive. warmness of the road choices include utilities, consumer staples stocks, and other dividend payers. Financial markets tend to anticipate Fed announcements. We always have to be on our toes for information/news relevant to QE. If you read the writings of Ben Bernanke and more recently writings by pile Bullard, you know the Federal Reserve is willing to use every quill and printing press in their arsenal in attempt to re-inflate asset prices and restore some semblance of the wealth effect. However, we must understand that the Fed faces high hurdles, in the form of mountains of global debt and fragile asset prices.So far, the U. S. has been able to get away with massive debts and unsustainable deficits for one simple reason. The U. S. dollar is still the cosmeas reserve currency, as it has been effectively since valet de chambre War II and literally since the early 1970? s. Because all governments and banks in the world accept and hold U. S. dollars as the majority of their reserves, the United States is able to simply print more money whenever it cannot afford to pay for things that it needs. Besides this, the country can borrow money in its own currency at incredibly low interest rates that we have seen approach close to zero.US citizens personally benefit in another critical way every time that they stop to get gas. With the U. S. dollar as the internati onalist reserve currency, oil and almost allcommoditiesare all priced in dollars. As a prove, you see an enormous amount of inexpensive goods available. provender items and other items that use oil/gas as inputs are extremely cheap. This makes restaurants and other attractions affordable in America. The level of wealth seen in the United States is simply unprecedented, and most of this results from the benefits of the dollar as universal reserve currency.There will be dramatic consequences difficult to imagine if the dollar eventually ceases to be the reserve currency of the world. Should this happen, then the value of the dollar will plummet. The immediate painful effects will be that commodities prices skyrocket. These would no longer be priced in U. S. dollars, and you would see the falling value of the dollar buy fewer and fewer commodities. Gasoline at five to ten dollars a gallon is not only possible, but highly likely. Along with higher gas prices, we could see higher pric es for anything that uses oil to ship goods around the world.This heart practically everything that you buy would all cost dramatically more. As prices skyrocket, your life-style would sustain a punishing drop overnight. This is a very scarey succession of possible events. Unfortunately, this is not the only consequence that you would see of a dollar that is no longer the reserve currency of the world. Interest rates would rise dramatically. They could easily reach ten to fifteen percent. This would wreck the housing market far worse than it is today. It would also cause the stock market to crash by almost half in a number of weeks.As the costs of supplies and materials go up with the falling currency value, businesses would be forced to cut back onemployeesbecause of their falling sales. Un duty could reach twenty to thirty percent or more as a result of this. As if this is not bad enough,inflationwould be sky high along with the rising prices and disappearing jobs. It is impo rtant to remember that the only thing that has to occur for all of these terrible things to happen is for other countries to prefer to be paid in anything besides U. S. dollars.In the event that non-United States holders of dollar-denominated assets decided to parapraxis holdings to assets denominated in other currencies, there could be serious consequences for the US economy. The gap of QE3 has some serious implications, although Bernanke has denied that there will be another round easing. The dollar has plunged nearly 20% against the euro over the last year and a half, a period that includes the run-up to and aftermath of the last round of quantitative easing, the Feds $600 billion bond-buying program known as QE2. But a QE3 may not pack the same dollar-slamming punch.If there is a QE3, the dollars fall could easily approach 10% on a trade-weighted basis against rival currencies, say David Woo, head of G-10 global rates and currencies research at Bank of America Merrill Lynch in rude(a) York. But the market is now more skeptical of the benefits of QE for the economy, Mr. Woo said. It is possible that by extension this means any short-term dollar decline on the back of QE3 will be also more limited. Instead of QE3, Bernanke and the Fed decided to implement Operation Twist, a widely expected stimulus move reviving a policy from the 1960s.The policy involves selling $400 billion in short-term Treasuries in exchange for the same amount of longer-term bonds, starting in October and ending in June 2012. While the move does not mean the Fed will eye additional money into the economy, it is designed to lower yields on long-term bonds, while keeping short-term rates little changed. The intent is to thereby push down interest rates on everything from mortgages to business loans, giving consumers and companies an additional incentive to borrow and spend money. Some reputable names deal the dollar is going to depreciate in value over the neighboring decade or t wo.Bestselling authors Robert Wiedemer of Aftershock and David Skarica of The Great Super Cycle both forecasted the housing collapse, financial crisis, and stock market collapse years ahead of them happening. They are calling for a collapse of the dollar. This could lead to many unsophisticated investors to hop on the train, causing a swing in practiced expectations. QE attempts to lower long term interest rates, keep them low for a fairly well-understood period of time, while flooding the economy with cash in an effort to boost consumption and investment.In my opinion, quantitative easing in the US was a mild success. The markets were in a state of fuse and we needed to do something. QE2 was necessary because we needed to increase the plateful to which the LSAPs (large scale asset purchases) affected the economy. As for QE3, I dont believe it is in our countrys best interest, because it would show even greater weakness, leading many foreign investors to flee from the dollar. Som ewhere down the line, I predict that the IMF will attempt to overtake the dollar as the world reserve currency, but it certainly wont happen overnight.If this happens, Americans will have to downgrade their wealthy standard of living due to increased commodity prices. However, I dont believe the US Dollar will lose its currency reserve status anytime soon, nor do I believe that QE3 will happen. My recommendation is to continue QE in small amounts, unwinding it under Bernankes plan from his September speech in Minneapolis. Bernanke has stated that there will be no more easing, but you never know with the Bernanke, Obama, Geithner brain trust. Thus, our best option is to remain flexible in our policy schemes and monitor and react to relevant news as best as we can.Ben Bernanke concludes his Minneapolis speech in an attempt to reassure us that our country will be okay. The Federal Reserve will certainly do all that it can to help restore high rates of growth and employment in a contex t of price stability. Let us confide they act with rationality and in the best interest of the long term growth and stability of our economy. If America is ever going to dig itself out of the enormous debts it has taken, we must not devalue the dollar to the point that it is phased out as the world reserve currency.Perhaps a downgrade in Americans standard of living is necessary to reduce the deficit by a significant enough margin. There is some swear for a return to prosperity and consistent growth, but Americans need to be aware of the implications of QE on their portfolios and their long term purchasing power. Works Cited 1. 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