The good ship QE2, as the Fed’s second round of quantitative easing is snappily known, is about to set sail, and we’re all aboard — whether we like it or not, says Guy Monson
WHILE STRIKES PARALYSE France and Britain embarks on £81 billion of torturous public-sector cuts, in Asia and much of the emerging world consumer demand is soaring, asset price inflation is rising and monetary policy is being tightened. In almost every application of policy there are near-perfect, 180° differences between ‘Old’ and ‘New’ Worlds.
This reversal of fortunes may be hard for many in the West to comprehend, but without today’s surging Asian consumption, and last year’s massive Chinese stimulus plan, the chances that the West could have avoided outright deflation — and perhaps depression — would be relatively slim. September’s alarmingly low US consumer inflation number (0.8 per cent on annual basis, zero on a monthly basis) shows just how close the world’s biggest economy has already come to Japanese-style, semi-permanent deflation.
Imagine the risk (or almost inevitability) of what Charles Evans, one of the US Federal Reserve governors, describes as a ‘bona-fide liquidity trap’, without the prop of last quarter’s blistering 9.6 per cent annualised GDP growth rate from China, 8.8 per cent from India and Brazil, and 6.2 per cent in Indonesia.
Indeed, it is this risk of a liquidity trap — the most feared of outcomes in Keynesian economic theory, a situation whereby no matter how low the central bank pushes interest rates, consumers refuse to borrow and banks are too nervous to lend — is being used to justify the recently announced ‘QE2’ measures by the Fed. Amid high controversy and much anticipation, the Fed declared its intention to embark upon a second round of Treasury purchases, amounting to $600 billion by mid-2011. Bernanke’s Fed is hoping that its substantial purchases of Treasury bonds will encourage investors to embrace risk-taking, bid up risk assets, ease financing costs, and ultimately feed through to higher economic growth.
Dramatically different economic conditions at the time of launch suggest that QE1 (March 2009) and QE2 might play out very differently. QE1 was implemented to restore confidence during a financial panic, with policy makers intending a ‘shock and awe’ impact on confidence, and was decided upon with little public discussion among domestic (let alone global) policymakers.
By contrast, QE2 is being introduced at a time of slow growth, with the explicit purpose of ‘revving up’ the growth engine so the economy can achieve some sort of escape velocity from deflation. William Dudley, president of the New York Federal Reserve, has argued that a QE programme of $500 billion equates to an interest-rate cut of about 50–75bps. As such, the FOMC’s $600 billion decision is at best almost equivalent to a 100bps interest-rate cut, while the Taylor rule (a guideline for prudent interest-rate manipulation) still suggests that interest rates need to be around –1.6 per cent.
THE ULTIMATE OBJECTIVE of QE2 is to reduce long-term interest rates and support an economic recovery through the reflation of asset prices across the risk spectrum. This is what happened in 2009, and markets expect history to repeat itself. But the path that this new domestic liquidity will take after it leaves US and UK central banks is not assured. Indeed, the last time we saw domestic money policy created on anything near this scale was probably the Japanese policy of zero interest rates in the mid-Nineties, which did little for Japanese growth or real-estate assets but (via the infamous ‘carry trade’) led to a quite extraordinary boom on Nasdaq and in growth stocks in almost every world market. Could something similar be happening in markets today?
If so, then the rally in world stock markets that began in March 2009 (when the first round of bond purchases by the central banks was announced) has much further to run as QE2 becomes a reality. While in Asia valuations are already looking expensive, liquidity is still so generous that further rises are very possible. But it is in the blue-chips of the ‘Old World’, which are so successfully selling their brands, intellectual property and technology (and often themselves) into the ‘New World’, where the real opportunities lie.
These classic ‘Nifty Fifty’-style global companies are reporting another excellent round of earnings this quarter, while the trauma of the financial crisis has caused them to boost cash flow and hoard liquidity. Their dividend yields, meanwhile, are often greater than those of government bonds (the latter driven by limited central bank money).
Of course, if the tentative signs of co-operation evident in October’s meeting of finance ministers in Seoul give way to acrimony and talk of trade barriers and capital restrictions, then all bets are off. However, if Indian PM Manmohan Singh’s appeal to world leaders for a ‘meeting of minds’ at the recent G20 Seoul summit turns out to have been successful, then a smaller QE programme in the West, coupled with a little more currency flexibility in the East, might unleash a quite surprisingly grateful response from Western stock markets.