10 most frequently asked questions about QE3

Moneycontrol Bureau

Quantitative easing or monetary easing is a tool used by central banks to improve the liquidity in the economy and revive growth. This is usually the last resort, when there is no scope for reducing interest rates further. Last week, US Federal Reserve chairman Ben Bernanke hinted that the central bank would consider another round of quantitative easing—the third since it was introduced in November 2008—though he did not spell it in as many words as the markets would have liked him to. Rating agency Credit Analysis & Research (CARE) decodes the 10 most frequently asked questions about QE3.

What is QE3?

QE3 stands for quantitative easing (third round), under which the US Federal Reserve will buy back bonds from banks so that they have more liquidity which can be used for lending purposes. These bonds could be government bonds or asset backed securities (ABS) depending on the way in which the Fed chooses. Basically, the Fed announces that it would buy back certain bonds with banks, which could be the relatively illiquid ones and then takes these bonds on its own books.

Which were the previous instances of QE by Fed?

Between November 2008 and June 2010, the Fed bought USD 2.1 trillion of bank debt, mortgage backed securities and government (Treasury) bonds. Between November 2010 and June 2011, the Fed went in for a second round of QE, buying USD 600 billion of treasuries. Further, Operation Twist was introduced and conducted by the Fed in late 2011 to help stimulate the economy. Here, the Fed bought longer-term Treasuries and simultaneously sold some of the shorter-dated issues it already held.

Why is the US Fed considering the third round of QE?

The Fed has kept rates down at 25 bps for a long time now. Yet there are signs of weakness with the unemployment rate being over the comfort level of 8%. Banks are still wary of lending since there is apprehension after the financial crisis. In fact even interbank lending has slowed down due to this concern even though the situation is much better than it was following the Lehman crisis.

What is the argument against QE3?

The earlier versions of QE were undertaken when the threat of recession and deflation were on the table, which does not appear to be the case today. This could set a precedent of similar such Fed involvement which may not be desirable on a sustained basis. It has been argued that with Operation Twist still running and long-term Treasury yields remaining low the Fed has already achieved its aim of migrating investors to riskier assets which in turn has allowed companies to borrow at very low interest rates.

How does quantitative easing impact interest rates and the economy?

An increase in liquidity with the banks will provide more resources for lending which should help to revive the economy. With less paper in the market, bond prices should go up which means that interest rates will get reduced automatically.

How does QE impact commodity prices?

More spending will automatically put (upward) pressure on commodity prices as demand increases. In particular, prices of metals and crude oil could tend to increase. If this happens, commodity price inflation at the global level cannot be ruled out.

How does QE impact major currencies?

The dollar would tend to weaken under these circumstances, which will have to be seen in the context of the euro also weakening on account of the crisis in the region. Therefore, the dollar-euro relation can tend to get even more volatile.

What are the side-effects of QE?

Interest rates can get distorted as the Fed buys back long term securities because long term yields will tend to come down sharply.

The problem with any kind of quantitative easing is that timing the exit is difficult because the markets tend to get fidgety when there is a withdrawal.

With interest rates also being at their lowest, there is a possibility of another asset bubble being created with a combination of excess liquidity and low rates.

The capital market will get a boost to begin with though the progress of the economy will largely be the driving factor in the medium run.

How will QE3 impact the rupee?

The rupee will tend to gain from dollar weakening to the extent that it happens which will help to prevent the present depreciation. However, rising commodity prices will pressurize the trade balance and would work in the other direction.

What are the other implications of QE for India?

More liquidity could mean more foreign investment coming into the country.

Global economic recovery will certainly help to provide a fillip to exports.

Possible commodity price inflation can add to our woes at a time when inflation is ruling high. Presently there is a semblance of normalcy in non-food prices, which could get upset with QE. This is the not so good news for India where policy makers are grappling with inflation.