Mixed signals from Fed's QE2 programme

Jim Caron, head of global interest rate strategy at Morgan Stanley, gives his take on QE2 in an interview with FinanceAsia, and argues that quantitative easing is already working.
Jim Caron, Morgan Stanley
Jim Caron, Morgan Stanley

On Wednesday, the US Federal Reserve (the Fed) launched a second round of quantitative easing (QE2) in a further attempt to stimulate the US economy. It is a drastic use of monetary policy that, by priming the banking and money market systems with liquidity, is intended to reduce interest rates, raise inflation expectations, and encourage credit creation. The aim is that this should lead to greater investment and spending.

Market participants and analysts were pleased by some of the features, but disappointed by others.

According to Jim Caron, head of global interest rate strategy at Morgan Stanley, the Fed has tried to balance “shock and awe” with a measured response. Total purchases of $600 billion are bigger than the financial markets expected – the consensus was $500 billion -- but monthly purchases of $75 billion worth of government bonds is less than the $100 billion widely forecast.

Also, the Fed’s purchases of US Treasury bonds will not extend beyond 10-year maturities; in fact, it will target bonds with durations of five to six years. Caron said there are two reasons for this strategy.

First, the five- to 10-year sector of the yield curve has the most impact on mortgage rates, and clearly one objective is to avoid any further build up of payment arrears -- or worse, defaults and foreclosures. Second, the Fed wants to prevent too great a fall in long-dated yields because insurance companies and pension funds would struggle to match their long-term liabilities with sufficiently high-quality and high-yielding assets.

But, Caron pointed out that in practice the buying programme is actually much greater than the headline figures suggest. The reason is that since August, the Fed has been buying Treasuries to shore up a $2 trillion balance sheet as mortgages and agency paper it bought two years ago, during the worst of the crisis, have been repaid early or matured. The net result, he said, is that total Fed purchases during the next eight months will more or less equal the total supply of new Treasury bond issuance.

On the other hand, the Fed did not say whether it may increase its purchases beyond $600 billion as part of its QE2 programme.

But, Caron argued that the quantitative easing (QE) is working already. His reasoning rests on four pillars: inflation expectations are on the rise; real interest rates have fallen; asset prices – especially equities, discounted by low interest rates – have increased; and the value of the US dollar has declined. These four conditions are creating an environment for more private corporate investment and household spending and, eventually, job creation.

But, he warned, “[QE] is a blunt, not a surgical instrument”. The unemployment rate (now 9.6%) will be the key indicator to watch as a sign that economic growth, fuelled by credit creation, is being restored, and that the recovery is sustainable.

“Many people are sceptical about whether QE will work, but I’m not one of them. The economic environment is in place,” said Caron.

The problem might be politics, in particular what happens in Washington, he warned. The next big event takes place in January, when a decision will be made on whether to extend the Bush-era tax cuts. Caron believes an extension is necessary to further stoke the flames of growth. “Fiscal management needs to work effectively,” he said.

Meanwhile, the impact on Asia ex-Japan is likely to continue as before. Capital will flow into the region’s equity, bond and property markets, strengthening currencies and importing inflation.

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