What exactly is QE2?

The Federal Reserve is widely expected to unveil a new round of quantitative easing (QE) later this afternoon in conjunction with a statement from its Federal Open Market Committee release on monetary policy. Michael Yoshikami, President and Chief Investment Officer of YCMNET Advisors in Walnut Creek, Calif. discusses what exactly QE is, why it may be needed and its potential impact.

IBT: What exactly is Quantitative Easing and how does it work?
YOSHIKAMI: When a central bank shifts its focus to expanding its balance sheet through the purchase of longer-term securities rather than targeting short-term interest rates, that is quantitative easing. Under QE, central banks inject the banking system with cash, increasing the quantity of reserves held by commercial banks. It’s a liquidity game. Such an increase can occur either directly, or indirectly.

IBT: How will QE be implemented?
YOSHIKAMI: For example, a central bank buys assets (securities such as government debt, mortgages, and commercial loans) from the commercial banks and credits their accounts with reserves by way of payment. Alternatively, a central bank buys assets from non-banks, and these non-banks then deposit the proceeds at commercial banks.

The bottom line is the resulting increase in reserves provides commercial banks with an opportunity to lend more. It is all about increasing liquidity. By increasing liquidity, the aim of QE is to foster an environment of growth by increasing inflation expectations, reducing real rates, and creating asset inflation.

IBT: Why is quantitative easing necessary now?
YOSHIKAMI: With the Fed Funds rate close to zero, QE is perhaps the only stimulative tool left for the Fed. After an initial burst of QE last year, the Fed’s view is that more is needed.

The economic issues that raise the specter of QE2 are many. Recent unemployment data has not been encouraging. The unemployment rate, at 9.6 percent in September, has stubbornly persisted at elevated levels. Jobs gains have been modest to say the least and it is not clear when employers will start hiring in meaningful numbers again.

September’s U.S. payroll report provided further evidence that the recovery has little forward momentum. Non-farm payrolls fell by 95,000 due in part to the loss of another 77,000 temporary census jobs. Private payrolls increased by 64,000, but this gain was more than offset by a 76,000 contraction in local government employment.

IBT: How does inflation and housing fit into this scenario?
YOSHIKAMI: Inflation is currently running at 1 percent [year-over-year], roughly half the rate that the Fed is targeting. In mid-October, Bernanke stated that since the excess capacity in the economy isn't shrinking, it is reasonable to forecast that underlying inflation...will be less than the mandate consistent inflation rate for some time. The Fed has an implicit inflation goal of 2 percent. Their objective is to move inflation higher.

September's CPI and retail sales figures reflect both low inflation and weaker economic growth. For the second month in a row, core prices did not increase. The 0.1 percent month-over-month increase in consumer prices was due to the combination of a 0.7 percent month-over-month rise in energy prices and a 0.3 percent month-over-month increase in food prices.

The annual core inflation rate fell from 0.9 percent in August to 0.8 percent, which is the lowest rate since March 1961, and well below the Fed preferred range of 1.5 percent to 2.0 percent. Deflation is within sight.

Housing prices are yet another concern. The overall U.S. housing market remains at depressed levels with no clear catalyst for near term improvement.

Existing homes sales rose 7.6 percent in August, but this followed a 27 percent decline in July. New home sales were flat in August. Housing starts in August did surprise on the upside, rising 10.5 percent to 598,000 from 541,000 in July, but both existing home sales and housing starts were driven by the volatile multi-residential sector.

Simply put, the economy is struggling. Proponents of QE2 find ample evidence for drastic monetary action.

IBT: Is there disagreement within the Fed board regarding the efficacy of QE?
YOSHIKAMI: [Yes]. not all agree with the Fed Chairman that QE2 is warranted. According to the Fed’s documents, some want to take action soon, while some members see merit in waiting for more information before reaching a decision and want to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus. Others argue that stimulus should only be provided if the outlook worsened and the odds of deflation increased materially. Others cautioned that the economic benefits could be small.

Chicago Fed President Charles Evans, highlighted what he viewed to be a “liquidity trap” that the U.S. economy is in, and warns that standard QE measures itself are not enough and more needs to be done. [He said] “in my opinion, much more policy accommodation is appropriate today” because “the US economy is best described as being in a bona fide liquidity trap.”

This means that ultra-low interest rates and high savings rates together makes standard monetary policy ineffective in a liquidity trap environment. Evans [also] suggested that the Fed should consider using a temporary target for the level of prices instead of the rate of inflation in order to convince businesses and consumers to stop saving and start investing and spending.

IBT: What about the views of other Fed members?

YOSHIKAMI: The messages from other Fed officials have also been somewhat mixed. Eric Rosengren of Boston, Narayana Kocherlakota of Minneapolis and Charles Plosser of the Philadelphia Fed all have different positions on everything from the inflation outlook to whether a second round of QE would boost economic growth at all.

Kocherlakota said QE2 would have a minimal impact compared to the $1.7 trillion purchases announced in March 2009 because the current markets seem to be functioning better than they were in 2009.
Plosser opposes further asset buying at this time and said that attempts to “fine-tune” the economy using QE is a threat to the Fed’s credibility and doesn’t see how additional asset purchases by the Fed, even if they move interest rates on long-term bonds down by 10 or 20 basis points, will have much impact on the near-term outlook for employment.

Rosengren, on the other hand, is showing his support, as monetary policy should react to a slow recovery “vigorously, creatively, thoughtfully and persistently, as long as we have options at our disposal.”

Obviously, consensus does not exist. Still, despite differing views, it is our belief that some form of quantitative easing will happen (or is happening). Markets have anticipated this and many believe
that is the reason for the recent equity market rally.

IBT: What really does the Fed hope to accomplish with QE2?
YOSHIKAMI: The bottom line is they seek to defeat deflation. It’s that simple. Here’s how they hope to achieve that goal.
First, if the Fed buys bonds, prices could rise, and their yields decline. So the Fed's buying will likely nudge down interest rates, boosting interest-sensitive spending on items like houses.

Second, since banks don't earn much on reserves, the process of QE introduces more reserves to banks that they can potentially lend out to make higher-returning loans to businesses and households. Ideally, it will hold mortgage and credit card rates low, and stimulate investment through low cost of capital. Banks need help as profits have plummeted in recent years.

IBT: If banks have excess reserves, will they lend?
YOSHIKAMI: They haven’t yet and seemed disinclined to do so. Concerns remain on the financial health of prospective borrowers. Capital standards have effectively reduced the ability of banks to leverage. Even if banks are willing to lend, businesses unsure about future prospects may not want to borrow even when interest rates are close to zero. If banks don’t lend then the power of quantitative easing would be mitigated.

Especially important to the economy is small business lending. Small businesses account for 65 percent of net new hires over the past 17 years. If QE2 is not effective in increasing small business employment, adds then the program will likely be stunted in its success.

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