Launch QE2 or Scrap It

Apparently the monetary authorities in both the US and the UK are thinking about a second round of quantitative easing (QE2), on top of $2350bn and £200bn of central bank asset purchases so far.

In the case of the UK, I’ll believe it when I see it, as inflation is already above the target range and we have a VAT rise to look forward to as we finish our Christmas turkey leftovers (I think the tax increase comes into effect, like a hangover, on New Year’s Day).

In the US, though, it seems the Fed could be serious.  They could do with a bit more inflation.  But they should put up or shut up.

The problem is that, whilst the short-term aim of QE is to reduce interest rates (longer-term aims are to prevent deflation, which is a good idea if you’re a debtor and – whisper it quietly – devalue the currency to try to export your way out of trouble), thereby encouraging private sector investment, the anticipation of QE could have the exact opposite effect on the cost of borrowing in the real economy.

The idea, of course, is that the central bank prints money to buy Treasuries (aka gilts).  A trillion dollars is enough to increase demand sufficiently to push up the price of the bonds, and their yield down.  Investors choosing between Treasuries and riskier instruments – e.g. and esp. lending to business – will tend to favour the latter and, hey presto, growth resumes.  Well, maybe.

But teasing the market could have a quite different effect.  Investors will figure that there might soon be huge demand for Treasuries.  So they pile in.  But at this stage there’s no new money in the economy.  To buy Treasuries our well-paid traders are smart enough to work out that they’re going to have to sell something else.  So the price of the other assets they sell – commercial loans and investments of all kinds – goes down, and – oops – the yield – that’s the interest rate to you and me – goes up.

Not only that, the prospect of QE creates inflation (and hence devaluation) worries for a certain class of investors so they pile into gold (as well as other currencies – helpful for the devaluation and hence inflation goals of QE, admittedly – and other “safe” assets).

Though the markets move in mysterious ways and it’s not a good idea to read anything into a day’s trading, it should perhaps not be a complete shock, then, that an FT columnist noted that:

“…the higher likelihood of QE2 did nothing for equities, which are flat to down.”

which is on the face of it is rather surprising as you’d have expected bets that QE happening would push prices up.  Perhaps there was buying on the rumour, selling on the news, on top of the move into Treasuries.  Or maybe there really are only so many dollars around and if you want to buy one asset you need to sell another…

In short, the idea of QE is to encourage investment in riskier assets.  Talking about it, I suggest, could achieve the precise opposite.

So I recommend that the Fed either starts QE2 pronto or publicly gives up on the idea.

In the UK the MPC should rule QE2 out, because the speculation (pun intended) is damaging, and the MPC is not in a position to crack the champagne on the bows.

Of course, it’s possible that all the QE talk is a device to help exporters by knocking a few % off the dollar and pound vs the yen and euro for a while.  I couldn’t possibly comment on that, though!  And I won’t even mention that QE talk is bound to reduce the cost of new  government borrowing…