Quantitative easing: A blessing or a curse Crisil Young Thought Leader 2012 Erica Fernandes PGDM (International Business) K.J. Somaiya Institute of Management Studies & Research (SIMSR), Mumbai [email protected]

Quantitative Easing: A Blessing or A Curse

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TABLE OF CONTENTS No. 1 1.1 1.2 1.3

Title Concept of Quantitative Easing Quantitative Easing Evolution of Quantitative Easing Reasons for Central Banks undertaking QE

Pg No 3-4 3 3 4

2

The Importance of Fed Quantitative Easing

4-5

3 3.1 3.2

The Impact of Fed QE

5-10 5 6

4 4.1 4.2

A State of Despair A Blessing in Disguise A. Liquidity & Interest Rates B. Flows into Emerging Markets C. A Glimmer of hope for the U.S. Economy Negatives of QE: The other side of the coin The two big issues A. Inflation B. Rise in Prices of Risky Assets The Deleveraging Argument

5

Conclusion

6 Figure 1 Figure 2 Graph 1 Graph 2 Graph 3 Graph 4 Graph 5 Graph 6 Graph 7 Graph 8 Graph 9 Graph 10 Graph 11 Table 1 Table 2

List of Figures/Graphs/Tables Channels of Fed QE Macroeconomic Analysis Quantitative easing conducted by Fed, BOE, ECB and BOJ Fed QE1 and LIBOR and EURIBOR (3 month) Fed QE1 and LIBOR (3 month) – Fed Fund (Spread in bps) Monthly QE by Fed vs monthly flows to EM equity asset funds Fed QE and Monthly U.S. Unemployment U.S. Five Yr Yield Breakeven Inflation Rate U.S. Ten Yr Yield Breakeven Inflation Rate QE Flows and Gold Price QE Flows and Crude Oil (Brent) Price QE Flows and Crude Oil (WTI) Price QE Flows and U.S. CPI Regression result: % Fed QE and % Flows to EM equity asset funds Correlations & Regression result: Fed QE1 and commodities

Quantitative Easing: A Blessing or A Curse

10-14 10 13 14

6 9 5 6 7 8 9 10 11 11 12 12 13 8 12

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EXECUTIVE SUMMARY: This paper examines whether Quantitative Easing (QE1) undertaken by the Federal Reserve (Fed) since 2008 is a blessing or curse. The methodology used was analysing the statistical impact of actual QE data on various economic variables during 2008-2012. The paper is divided into five sections. Section 1 defines QE and its relevance. Section 2 compares actual QE done by major central banks like the Fed, ECB, BOJ and BOE and concludes why Fed QE was the most significant. Section 3 analyzes the positive impact of QE on interest rates, employment, portfolio flows into emerging markets. Section 4 analyzes the fallout of Fed QE by tracing rise in inflationary expectations & commodity prices after QE started. Finally, we conclude that QE may be a blessing or a curse depending on the landscape of the economy. INTRODUCTION: In the aftermath of the 2008 financial crisis, followed by the Euro Crisis, major Central Banks (CBs) responded by unconventional monetary policy measures namely, Quantitative Easing (QE). On one hand, QE provided easy liquidity to banks and pushed lending but QE not only impacts home country economies but also is transmitted across geographies and asset classes. Questions arise as to whether QE is positive or negative for world economies. In the rest of the paper, we discuss the argument as to whether QE is a blessing or a curse. 1. CONCEPT OF QUANTITATIVE EASING: 1.1 Quantitative Easing: The term Quantitative Easing (QE) is a monetary policy measure that central banks (CB) use so as to increase the money supply in an economy. It is done when the bank interest rate, discount rate and/or interbank interest rate is close to or at zero levels. The CB first credits its own account with money it has created out of nothing, followed by purchases of financial assets via open market operations. 1.2 Evolution of Quantitative Easing Early 2000s: The evolution of the concept of QE can be credited to the Bank of Japan (BOJ) which coined the expression for quantitative easing “kanwa”. The hardened stance of the policy adopted by Quantitative Easing: A Blessing or A Curse

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the BOJ on March 19, 2001 was in fact QE. After Toshihiko Fukui was appointed governor of BOJ in February 2003, it became the established official view. Late 2000s: More recently, QE has been used as a measure of last resort. These extraordinary circumstances (2008 crisis, Euro crisis) first pushed the CBs of these countries to cut policy rates to historic low rates. But as economic conditions continued to be grim, central banks chose to initiate QE as a monetary policy action. 1.3 Reasons for Central Banks undertaking Quantitative Easing QE is employed to increase the money supply in the financial system. The increase in reserves of banks allows them to lend more. Also when the central bank buys bonds as a part of QE, this leads to lower yields on government bonds and similar investments, making it cheaper for business to raise capital. Investors are able to swap investments in financial assets like shares and bonds and thus enable them to increase their portfolio wealth and reduce risk. QE also helps in reducing interbank overnight interest rates 2. THE IMPORTANCE OF FED QE Central Banks that have undertaken QE between 2008 and 2012 were the FED, ECB, BOE and BOJ. To measure the amount of QE, we analyzed Fed’s weekly reserves data which shows the outstanding amount of various securities held for each of these banks. We then used net change in total securities held as a proxy variable for Fed QE. For the ECB, we looked at aggregate of 3 main operations conducted by the ECB: SMP started in 2011; LTRO which started in Dec 2011 and covered bond purchases. For the BOJ, data was obtained on CP, corporate bonds and JGBs purchased by the BOJ.

Quantitative Easing: A Blessing or A Curse

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GRAPH 1: Quantitative easing conducted by Fed, BOE, ECB and BOJ USD mn

600000

Fed

BOE

ECB

BOJ

500000 400000 300000

200000 100000

Jun-12

Aug-12

Apr-12

Feb-12

Dec-11

Oct-11

Aug-11

Jun-11

Apr-11

Feb-11

Dec-10

Oct-10

Aug-10

Jun-10

Apr-10

Feb-10

Dec-09

Oct-09

Jun-09

Aug-09

Apr-09

Feb-09

Oct-08

Dec-08

Jun-08

Aug-08

Apr-08

-100000

Feb-08

0

-200000

Source: Federal Reserve, ECB, BOJ, BOE Data Releases

The findings in Graph 1 show that the Fed was the most significant of all the major central banks in terms of the magnitude of bond purchases throughout the entire period except late 2011 when the ECB did LTROs. Also, Fed was the first major central bank to embark on QE. Thus for the purpose of the central argument of this paper, we will try to understand the impact of Fed’s QE. 3. IMPACT OF FED QE 3.1 A State of Despair Prior to Fed QE1 the money markets were in a state of despair: 1.

Credit Crunch: Banks with excess liquidity were not willing to lend to those

requiring the same even at premiums leading to a credit crunch.

2.

Short end rates at record highs: During the 2007-08 crisis the interbank rates

namely LIBOR and EURIBOR were at elevated levels as a result of combination of Liquidity and credit risk known as distress risk. 3.

Economic recession in the U.S: The financial crisis led to a recession in the U.S

leading to a fall in GDP, increased unemployment, reduced investment spending, bankruptcies and write-offs by businesses.

Quantitative Easing: A Blessing or A Curse

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3.2

A Blessing in Disguise

When Fed started with QE1 in Dec 2008, equity markets improved with the S&P 500 index climbing 2.09 per cent to 794.35 on March 18, 2009, the yield on US benchmark 10-year Treasury notes and bank lending stabilizing. The Impact of QE1 is seen in each of the following:

A.

Liquidity and Interest rates:

The channels through which QE operates affecting liquidity and interest rates are as given: FIGURE 1: Channels of Fed QE

Signalling Channel

Feds announceme nt

Interpreted as low short term rates in the future

Market expectations about the future

Affects all interest rates

Liquidity channel

Purchasing Long term securities

Increasing reserve balances

Increase in liquidity

Reduced premium on most liquid bonds

Market Functioning channel

Panic and low liquidity in markets

Fed intervention calmed investors

Supported range of asset prices

Increase in treasury yields

The other immediate impact of Fed QE was on short end interest rates, shown in the Graph below: GRAPH 2: Fed QE1 and LIBOR & EURIBOR (3 month) %

Usd mn

Total QE

Euribor 3m

Libor 3m

Jan/08 Mar/08 May/08 Jul/08 Sep/08 Nov/08 Jan/09 Mar/09 May/09 Jul/09 Sep/09 Nov/09 Jan/10 Mar/10 May/10 Jul/10 Sep/10 Nov/10 Jan/11 Mar/11 May/11 Jul/11 Sep/11 Nov/11 Jan/12 Mar/12 May/12 Jul/12 Sep/12 Nov/12

250000 200000 150000 100000 50000 0 -50000 -100000 -150000

Source: Fed Reserve, British Banker Association, European Banking Federation Data Releases

Quantitative Easing: A Blessing or A Curse

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10 9 8 7 6 5 4 3 2 1 0

We see that LIBOR and EURIBOR spiked in Sept 2008 as a result Lehman bros collapsing, followed by tight credit conditions and the shortage of US dollars. The Fed started its rate cut cycle on Sept 18th 2008 so as to ease money market rates but as seen from the Graph it was only after Fed QE1 began in Dec 2008 that rates (in particular LIBOR 3m and EURIBOR 3m) actually began showing signs of stabilizing. GRAPH 3: Fed QE1 and LIBOR (3 month) – Fed Fund (Spread in bps) Usd mn

Bps

250000 200000 150000 100000 50000 0 -50000 -100000 -150000

Total QE

Libor -Fed Fund (spread in bps)

250 200 150 100 50 0

Jan/08 Mar/08 May/08 Jul/08 Sep/08 Nov/08 Jan/09 Mar/09 May/09 Jul/09 Sep/09 Nov/09 Jan/10 Mar/10 May/10 Jul/10 Sep/10 Nov/10 Jan/11 Mar/11 May/11 Jul/11 Sep/11 Nov/11 Jan/12 Mar/12 May/12 Jul/12 Sep/12 Nov/12

-50

Source: Source: Fed Reserve, British Banker Association Data Releases

Graph 3 shows the Libor 3m rate surged to a record high (200bp) above the Fed fund rate, indicating financial stress. However announcement of QE, and the subsequent resumption of inter-bank lending caused the Libor rates to normalize. Libor rates came down to the normal spread of 0-50bp above the Fed Fund rate once QE began. B. Flows into Emerging markets (EMs) Fed QE1 not only impacted the U.S economy but also led to flows outside US, into emerging markets. This is explained with the aid of an empirical study. Aggregate flows into EMs are taken from a database, i.e. EPFR Global which tracks aggregate flows into all mutual funds that invest in local currency debt and equities of EMs. We derived fund equity funds on an aggregate basis.

Graph 4 suggests that Fed QE did lead to a pickup of inflows into EM equity mutual funds, although with lag. Also QE1 seems to have had a larger impact on fund flows. However, the impact of QE on EM flows reduced with time.

Quantitative Easing: A Blessing or A Curse

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GRAPH 4: Monthly QE by Fed vs monthly flows to EM equity asset funds (USD mn) Monthly flow US$mn 15,000

Monthly, US$mn 2,50,000 2,00,000

QE1

10,000

1,50,000 1,00,000

5,000

50,000 0

0

-50,000 -5,000

-1,00,000

QE2

-10,000 -15,000 Jan-07

-1,50,000

Inflows into emerging market equity funds Increase in securities held by US Fed (QE) - right axis Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

-2,00,000 -2,50,000

Jan-12

Jul-12

Source: EPFR, Federal Reserve Data Releases

Regression of QE vs emerging market (EM) Equity fund flows Factors to consider for regression: Choice of independent variable (X) – Percentage change in monthly assets held by Fed Choice of dependent variable (Y): Percentage monthly flows to emerging market equity funds. Time period of study: From Dec 08 when QE1 started until 2012 or just period of QE1 – Dec 2008 to March 2010 We now construct the regression hypothesis: Null hypothesis: H0 - There is no relationship between QE flows (X) and emerging market flows (Y) Alternate hypothesis: H1 - There is a strong correlation between QE and flow into emerging market funds

TABLE 1: Results of regression between Fed QE (%) and Flows (%) to EM equity asset funds X Y Fed QE (%) % Increase EM equity fund assets Fed QE (%) % Increase EM equity fund assets *best result marked in grey

Sig (95%) Lag Time BETA CORREL R2 2008-2012 0.94 0.67 0.45 0.00 1m QE1 0.92 0.72 0.52 0.00 1m

From the regression, we are able to reject the null hypothesis (with 95% confidence) that there is no relationship between QE (flows %) and growth in EM equity funds. QE did have a statistically significant effect on EM equity fund flows with a lag of just 1 month Quantitative Easing: A Blessing or A Curse

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with a very high correlation. The relationship is strongest during QE1 (from Dec 2008 to March 2010). A 1% increase in Fed’s assets led to a 0.92% increase in EM equity funds assets during QE1. Thus there is a strong relationship between EM fund flows and QE. The relationship is strongest for QE conducted by Fed during QE1 (Dec 08 – Mar 10) C. A Glimmer of hope in the US Economy Another positive impact of Fed QE was the signs of a recovery it brought to the US economy. Many see Fed QE as one of the reasons for improvements in U.S unemployment data. How did it work?

FIGURE 2: Macroeconomic Analysis

Fed buys assets from banks

Consumers and businesses borrow to purchases or expand businesses

Drives down yields and interest rates

Businesses hire more and unemployment declines

Economy grows

A look at the Graph below confirms the same:

GRAPH 5: Fed QE and Monthly U.S. Unemployment Usd mn

250000

Total QE

200000

Home Unemployment %

12 10

150000 8

100000 50000

6 Oct/12

Jul/12

Apr/12

Jan/12

Oct/11

Jul/11

Apr/11

Jan/11

Oct/10

Jul/10

Apr/10

Jan/10

Oct/09

Jul/09

Apr/09

Jan/09

Oct/08

Jul/08

-100000

Apr/08

-50000

Jan/08

0

-150000

4 2 0

Source: Source: Fed Reserve, Bureau of Labour Statistics Data Releases

The unemployment rate in the U.S was climbing prior to Fed QE1. When QE1 started in Dec 2008, the unemployment rate remained sticky between 8.3 to 9.5 levels. Thereafter, Quantitative Easing: A Blessing or A Curse

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unemployment began to gradually decline, coinciding with the time period when Fed QE2 took place between Nov 2010 and June 2011. It is possible that the drop in the unemployment rates to lower levels can be attributed to QE as well as other fiscal measures taken by the U.S Government. 4. THE NEGATIVES OF QE: THE OTHER SIDE OF THE COIN There are two sides to an argument. The positives were iterated earlier, we now move on to the critics view on QE

4.1 The two big issues There are two main problems associated with QE. The first being inflation and the second is the rise of prices of risky assets. Both these problems are linked to each other.

A. Inflation QE has blamed to have set off rising inflationary expectations. This is because QE increases money supply leading to increased ability of individuals and firms to spend, which in turn leads to demand-driven inflation. We tried to understand this relationship by deriving inflationary expectations in the US. We use the Fisher’s rule to derive 5y and 10y inflationary expectations from the TIPS bond yield (real yield) and the US Treasury bond yield (nominal yield).

GRAPH 6: U.S. 5 Yr Yeild Breakeven Inflation Rate (5 Yr Inflation Expectations %) Usd mn

250000 200000 150000 100000 50000 0 -50000 -100000 -150000

3 Total QE

5y inflation expectation

2.5 2 1.5 1 0.5 0

Jan/08 Mar/08 May/08 Jul/08 Sep/08 Nov/08 Jan/09 Mar/09 May/09 Jul/09 Sep/09 Nov/09 Jan/10 Mar/10 May/10 Jul/10 Sep/10 Nov/10 Jan/11 Mar/11 May/11 Jul/11 Sep/11 Nov/11 Jan/12 Mar/12 May/12 Jul/12 Sep/12 Nov/12

-0.5

Source: Fed Reserve Data Releases

Quantitative Easing: A Blessing or A Curse

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GRAPH 7: U.S. 10 Yr Yield Breakeven Inflation Rate (10 Yr Inflation Expectations %) 250000 200000 150000 100000 50000 0 -50000 -100000 -150000

Total QE

3

10y inflation expectation

2.5 2 1.5 1 0.5

Jan/08 Mar/08 May/08 Jul/08 Sep/08 Nov/08 Jan/09 Mar/09 May/09 Jul/09 Sep/09 Nov/09 Jan/10 Mar/10 May/10 Jul/10 Sep/10 Nov/10 Jan/11 Mar/11 May/11 Jul/11 Sep/11 Nov/11 Jan/12 Mar/12 May/12 Jul/12 Sep/12 Nov/12

0

Source: Fed Reserve Data Releases

It is evident from both Graphs that prior to Fed QE, deflation hit the U.S economy. However, after Fed QE, 5y and 10y inflation expectations rose. B. Rise in Prices of Risky Assets Empirical study on impact of QE on particular commodities prices We examine the relationship between Fed QE1 and particular commodities like Gold and Crude Oil. Crude Oil includes both Brent and WTI data. GRAPH 8: QE Flows and Gold Price (USD)

250000

QE flows

200000

GOLD Comdty

150000 100000 50000

-150000

Jul-12

Apr-12

Jan-12

Oct-11

Jul-11

Apr-11

Jan-11

Oct-10

Jul-10

Apr-10

Jan-10

Oct-09

Jul-09

Apr-09

Jan-09

Oct-08

Jul-08

-100000

Apr-08

-50000

Jan-08

0

2000 1800 1600 1400 1200 1000 800 600 400 200 0

Source: Federal Reserve and World Gold Council Data Statistics

Quantitative Easing: A Blessing or A Curse

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GRAPH 9: QE Flows and Crude Oil Brent Price (USD)

Jul-12

Apr-12

Jan-12

Oct-11

COA Comdty

Jul-11

Apr-11

Jan-11

Oct-10

Jul-10

Apr-10

Jan-10

Oct-09

Jul-09

Apr-09

Jan-09

Oct-08

Jul-08

Apr-08

QE flows

Jan-08

250000 200000 150000 100000 50000 0 -50000 -100000 -150000

160 140 120 100 80 60 40 20 0

Source: Federal Reserve and U.S. Energy Information & Administration Database

GRAPH 10: QE Flows and Crude Oil WTI Price (USD) 250000

QE flows

200000

CL1 Comdty

160 140

Jul-12

Apr-12

Jan-12

Oct-11

Jul-11

Apr-11

Jan-11

Oct-10

Jul-10

Apr-10

-100000

Jul-08

-50000

Jan-10

60 Oct-09

0 Jul-09

80 Apr-09

50000 Jan-09

100

Oct-08

100000

Apr-08

120

Jan-08

150000

-150000

40 20 0

Source: Federal Reserve and U.S. Energy Information & Administration Database

Graph 8 illustrates that Gold prices lead QE by two months. So, Gold prices start to price in QE even before the actual announcement. While Graph 9 indicates Brent lags by three months and WTI lags by two months in Graph 10. The correlation and regression analysis for each of the countries is as given below. TABLE 2: Results of correlations & regression between Fed QE1 and commodities – Gold & Crude Oil CORRELATION

R2

ADJUSTED R2

SIGNIFICANCE LEVEL (95%)

Gold

0.20301883

0.041217

-0.018707315

0.419110018

Crude Oil (Brent)

0.565992164

0.320347

0.277868826

0.014346676

Crude Oil (WTI)

0.501983454

0.251987

0.205236599

0.033775449

COMMODITY

Source: Federal Reserve and U.S. Energy Information & Administration Database

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Using a 95% Confidence level we establish that there is a significant relationship between QE1 and Crude Oil. Table 3 shows that the Correlation between the Fed’s QE1 and Gold is moderate at 20% while for Crude Oil, both Brent and WTI is above 50% which is moderately strong. Thus, countries which are dependent on Oil and other commodities may have experienced a rise in inflation as a result of QE. Does QE lead to higher actual inflation? GRAPH 11: QE Flows and U.S. CPI (%) Total QE

250000

US CPI Index (YoY)

200000 150000 100000 50000 Oct/12

Jul/12

Apr/12

Jan/12

Oct/11

Jul/11

Apr/11

Jan/11

Oct/10

Jul/10

Apr/10

Jan/10

Oct/09

Jul/09

Apr/09

Jan/09

Oct/08

Jul/08

-100000

Apr/08

-50000

Jan/08

0

-150000 Source: Federal Reserve and World Gold Council Data Statistics

The earlier findings pointed out that inflation to a certain extent is caused by QE because of the commodities within the basket of goods used to calculate inflation. However, on an aggregate basis, a look at the relationship between U.S. CPI and Fed QE tells a different story. The graph shows that Fed QE1 brought deflation into positive territory but overall CPI in US has remained flat thereafter within the range of -1% & 0.6%. Thus, QE did help to address deflation risks in the US economy. But there is little substance in the argument that Fed QE did lead to an actual rise in CPI inflation. 4.2. The Deleveraging Argument explains why CPI did not rise in spite of QE: Inflationary expectations are dependent on the economy as well as the velocity of money circulation and the level of financial stress. If banks are risk averse and decide to hold liquid assets acquired from the central bank or if demand for loans in the economy is flat, then QE does not lead to any upward pressure on inflation. Considering that the crisis has resulted in increase in corporate and individual savings rates and declining risk appetite world over,

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6 5 4 3 2 1 0 -1 -2 -3

rising inflation cannot be a result of QE alone. However we can attribute partial rise in inflation to increasing commodity prices. 5. CONCLUSION Finally, QE can neither be characterised as a blessing or a curse. During the crisis of 2008, Fed QE, i.e. QE1 was used as a tool to combat deflation, deceleration in growth rate, tight credits markets and rising interest rates and bring about stability. However not every solution can be a perfect one especially in such an uncertain landscape. Thus the benefits of QE come at the cost of inflation and rising global asset prices. Empirical analysis shows us that there is no direct relationship between QE & US CPI inflation but it is possible that deleveraging of the U.S financial system could have minimized the impact. Finally one needs to bear in mind that the shortcomings of QE are dependent on the situation of the country’s economy. REFERENCES 1. The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy, Arvind Krishnamurthy and Annette Vissing-Jorgensen2,September 12, 2011 2. The financial market impact of quantitative easing Michael Joyce, Ana Lasaosa, Ibrahim Stevens and Matthew Tong, Working Paper No. 393, July 2010, revised August 2010 3. Monetary Policy under Zero Interest Rate: Viewpoints of Central Bank Economists, Hiroshi Fujiki et. al.,Monetary and Eonomic Studies, February 2001 4.

Impact of US Quantitative Easing Policy on Emerging Asia, Peter J Morgan, ADBI Working Paper Series November 2011

5. Stress in Bank Funding Markets and implications for Monetary Policy- Global Financial Stability Report,, IMF External Publications 6. Liquidity Effects of Quantitative Easing on Long-Term Interest Rates, Signe Krogstrup, Samuel Reynard and Barbara Sutter, Woking Paper, Swiss National Bank, 2012 Websites: 1. Bank of Japan website: www.boj.or.jp/en/mopo/measures/mkt_ope/ope_m/index.htm/ 2. Federal Reserve website: Quantitative Easing: A Blessing or A Curse

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http://www.federalreserve.gov/econresdata/default.htm 3. Bank of England website: http://www.bankofengland.co.uk/statistics/Pages/calendar/default.aspx 4. Emerging Portfolio Fund Research, Inc. website: http://www.epfr.com 5. Bloomberg Inc. website: http://www.bloomberg.com

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