Wednesday, November 17, 2010

The Printing Press

Recently The US federal Reserve announced it's plans for the second round of quantitative easing. The US fed should complete this 600 billion bond-buying program in the next eight months. The US Fed printing all this money to prevent the economy for going into a double dip recession.
In the last decade the two countries to have used this route were japan and Zimbabwe, both have failed miserably to revive their economy through quantitative easing. The increase in money supply has caused hyper-inflation in Zimbabwe and has failed to stimulate the Japanese economy, through these actions the central banks in these countries have been acting like a printing press. However it has to be noted that quantitative easing is used when the central banks are left with no other options. The interest rates in the US is close to zero, so QE2 was the last option with the US fed to tackle recession.
The bigger question that the federal reserve has to answer is that- will QE2 bring any significant changes to the economy?
Inflation in the US has been very low. The high unemployment rate has been one of the main reason for these low inflation figures, hence the increased money supply should not cause much problems in the short run. It can be noted that despite the increase in money supply after QE1, the inflation US has been stable. The main reason for stable inflation is because of the falling velocity of the greenback. the money supply has been rising but the falling velocity (circulation of currency) has been the main reason behind the failure to improve the economy.
Banks in the US are sitting on surplus reserves and the increased liquidity should only inflate this surplus reserves. The problem is the lack of confidence to lend. Fear of defaults in the US is the main reason behind the falling velocity of the US dollar. There are not many lucrative investment options in the US and this is forcing the dollar to move out of the US system to much greener pastures in Asia. The increase in supply of dollar is one of the main reason for the rise in emerging market equities and precious metals. The only positive impact that is visible through this policy is that this increase in supply should depreciate the dollar making US exports more attractive. Despite the fall in dollar it is going to be very difficult to compete with the Chinese exports mainly because of the pegged Renminbi. The bond purchase should bring the prices of the US treasury higher, but a depreciating dollar may prevent the central banks from making any significant inflows into the US treasury. The spike in gold prices is a clear indication suggesting that the central banks are looking at better options to invest their surplus reserves.
The emerging markets are witnessing huge amounts of capital inflows, this should further give rise to protectionist policies to prevent the domestic currencies from appreciating. The bigger worry for the emerging economies should be the probability of a bubble in metals and crude. The rise in inflows should fuel inflation, and it may in the end force countries like India too to implement capital controls. Looking at the recent monetary policies of China and South korea it is clear that the countries in Asia are going to use liquidity tightening measures to fight the threats they could face due to QE2. The currency wars between nations seems to have fueled the speculation that the world is moving towards a new exchange rate system, the World Bank president Robert Zoellick too seems to have joined these speculators.

The news flows from the European union continues to disappoint. Analysts predict Ireland could face a potential default. The bond yields have risen by more than 500 basis points. It is just a matter of time before the ECB announces a bail out package for Ireland. The most troubling part about the situation in Europe is that the toxic assets gets transferred from banks to the government and then to mightier organizations like the IMF and the ECB. This may lead to greater problems considering the fact that there may be many more nations in line waiting for a bailout.
It is now going to be interesting to see how the emerging markets tackle inflation worries and how the US and the EU deal with their set of problems.