27 September 2010

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Why the QE2 is not sailing

Central bank policy is, once again, attracting attention. There have been reports that quantitative easing (QE) will be embraced by central banks, in an effort to stimulate an economy and avoid the risk of a double dip. Some commentators have gone to call this QE2 — a second wave of quantitative easing.
However, there is a problem with this phrase. The QE2 is not about to set sail across the turbulent waters of the world economy, because the QE1 has not yet left the dock (with the sole exception of Japan). We do not have quantitative easing in the global economy today — we have quantitative policy.
Understanding the distinction between the two terms is absolutely critical if investors want to understand what central banks are doing.

Any central bank has basically two policy options with regards to domestic policy. Either the central bank targets interest rates (which is the convention in most economies) or they can target the money supply (and let interest rates float where they will). Setting a target for the quantity of money in an economy is a quantitative policy (the clue is in the name) — and this is what we have at the moment.
Quantitative easing is the superhero version of quantitative policy (QP). Quantitative easing occurs when central banks pursue quantitative policy and print money, but also commit to keeping that policy in place until some external target is met. So, for example, in 2001 the Bank of Japan was printing money, but was making it clear that it was not a quantitative easing process.
In 2003, the Bank of Japan started to make it known that it would continue to print money until the Japanese inflation rate turned positive. Investors then knew that the metaphorical printing presses would keep operating until an external target was achieved — and that the Bank of Japan would not abandon its printing program until that point. Quantitative policy became full quantitative easing.
Why do economists care about the distinction? Economists (and policy makers) care, because there is a huge difference between a policy that aims to inject liquidity (quantitative policy) and a policy that aims to influence expectations (quantitative easing).
A central bank may chose to pursue QP because of ideology (monetarism is generally implemented through QP). A central bank may chose to pursue QP because it wants to provide stimulus to the economy.
However, a central bank may also choose to pursue QP to provide liquidity to the banking system — without regard for the economic situation at all. Obviously, there are complicated factors behind QP today, but banking system liquidity is a key part of this. However, with the possible exception of Japan, central banks are not yet willing to pursue quantitative policies.
Fed chairman Bernanke was quite explicit about this at the recent Jackson Hole economic gathering — one possible option for future monetary easing that he highlighted was changing the language of  the Federal Open Market Committee (FOMC) statements so as to change expectations about the duration of policy accommodation (i.e. move to QE). However, Bernanke also highlighted that there was no need to change economic inflation expectations — a position which contrasts with his very public stand on Japan’s monetary policy in 2003. 
So what does this mean for the world?
Quantitative policy is something that is not likely to spread beyond its immediate borders. Quantitative policy may support growth (which is a good thing) but generally speaking the money that is supplied to the financial system will be absorbed by the financial system — it does not leak out. In particular currency markets will not be able to get a hold on the new cash. Foreign exchange investors who want to own some of the dollars that the Fed has been providing are likely to be disappointed — the Fed’s money goes to US banks and stay there.
If a central bank shifts to full QE, then things are different. The central bank is deliberately setting out to influence expectations and thus the real economy. In doing so, the central bank is far more likely to print surplus money — more than the banking system or what the domestic economy actually needs.
That money can leak into higher domestic prices (which very often will be the aim of the central bank) or it can leak into the foreign exchange markets (where it will weaken the currency). QP is a domestic affair. QE can have global connotations.
There are many reasons to keep QP in place at the moment, and we expect that most of the world’s major central banks will stay on a QP tack. Some, indeed, may increase the scope of QP. However, there are few reasons to charter a course to QE. Long term expectations have not shifted that much, and as central bankers are making clear there is no real reason to pursue QE yet. Japan is perhaps closer than most to a full QE policy, but for the rest of the world QE is not going to sail.

Paul Donovan, The writer is deputy head, Global Economics, UBS Investment Bank.
Opini The Jakarta Post 27 September 2010