Has QE2 worked?

December 16, 2010

— Kathleen Brooks is research director at forex.com. The opinions expressed are her own. —

Ever since the U.S. Central Bank formally announced its second round of quantitative easing back in November, bond yields have trended higher. Ten-year Treasury yields have jumped by 100 basis points and are back at levels last reached in May 2010. Higher yields underpinned the dollar, which has risen by more than 5 percent over the same time period. So what does this tell us about the market, and has the Fed’s grand plan actually backfired?

Those in the ‘yes’ camp argue that quantitative easing was designed to help the most interest rate-sensitive sectors in the U.S. economy such as the housing market. However, the housing market in the U.S. remains depressed and rising Treasury yields are pushing up long-term mortgage rates, which on average rose to 4.86 percent in the week ending 10 December up from 4.66 percent the week before.

Rising borrowing costs are unlikely to attract buyers to purchase homes especially when house prices continue to fall. Without a convincing recovery in the housing market they argue, it is difficult to see how consumption and  growth can pick up to levels that will ward off deflation and help push the unemployment rate lower.

So what about those who believe the Fed did the right thing and QE2 is working? They say that QE2 will work with a lag and so-far-so good. Since Fed Chairman Bernanke first touted the idea of more QE back in August he has helped to re-flate the global economy after the financial crisis threatened to cause the worst depression since the 1930s.

While inflation isn’t showing up in consumer prices (core inflation in the U.S. remains a fairly meagre 0.8 percent) it is very much alive in the stock markets and in commodities fuelled by Fed-generated liquidity. Global stock markets have reached pre-Lehman Brothers highs and commodity prices are also reaching record levels; for example, oil is back above $90 per barrel.

This signals that investors are willing to take on more risk, and a risk-on environment is always inflationary. In contrast, a risk-off environment is deflationary as it signals weak growth. The key to sustaining the U.S. recovery is inflation. Thus QE2 was necessary to promote inflationary forces that, after a lag, will finally start to show up in the U.S. economy. Once prices are rising in line with the Fed’s 2 percent annual target then the unemployment rate should start to recede and, hey presto, the Fed has achieved its duel mandate and saved the economic day.

But QE2 may have a short life-span. Even though Bernanke has left the door open to QE3 or even 4, the extension of the Bush tax cuts and the payroll tax cut will probably render this unnecessary. QE2 was designed to plug the holes in the U.S. recovery when stimulus from elsewhere was not forthcoming. But economists now believe that this fiscal stimulus will boost growth by anything up to 2 percent in the coming years, which should free the Fed from purchasing large quantities of Treasuries and massively expanding its balance sheet.

There is also another angle to this debate. Although there is a strong argument that QE2 worked, it came at a huge political cost. The policy was criticised across the world, and the U.S. was accused of currency debasement and fuelling a currency war. The main charges came from emerging markets where the U.S. should be building bridges and forging new relationships. Time will tell if the Fed’s second go at monetary stimulus has permanently damaged America’s reputation in the emerging world.

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