The crippling effect of QE3

October 29, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

It was tried twice before and it is being tried once again. Whether quantitative easing (QE3) will increase employment in the United States is questionable. But it will certainly disturb currency exchange rates of emerging market economies with related consequences.

The Federal Reserve took three major monetary decisions last September. First, it will buy $40 billion  mortgage-backed securities every month indefinitely until there is improvement in the labour market; second, it extended ‘Operation Twist’ entailing purchase of long-term bonds against short-term bonds till the end of 2012; third, it will continue its near-zero interest rate guidance until mid-2015.

These measures have huge implications for the United States and for the rest of the world. They will amount to pumping in $184 billion in the three months ending 2012 and $40 billion a month thereafter. This infusion of liquidity is intended to hold mortgage rates down which are already very low.

The expectation is that people will be tempted to buy homes which will restart construction activity. After the 2008 financial crisis, housing activity had collapsed and it is necessary to bolster it to generate employment and growth. Also, the low rate of interest and easy loans can stimulate demand generally and consequently investment, though in the past four years, results have not been commendable. At best, a part of the liquidity pumped in by the Fed may get into domestic circulation.

More likely, excess liquidity will be used for speculation which will lift asset prices internationally. The announcement of QE3 instantly pushed up stock prices not only in the United States but all major stock markets of the world. The other assets that will attract investment are crude oil and gold. Since infusion of liquidity will be gradual, the inflation in asset prices will also be gradual with characteristic volatility.

A large part of the liquidity, however, will spill into emerging market economies (EMEs) for short-term and long-term investment. Philippines, Singapore, South Korea, Brazil, Taiwan, etc. are already feeling the heat with their currencies hardening against the dollar. Some of these currencies appreciated about a percent.

The spillover of QE3 liquidity will force the central banks of EMEs to intervene in the currency markets to retain their competitiveness in exports. That would mean purchase of dollars and consequently excess liquidity, resulting in inflation. Interest rates will rise and consequently investment and growth will shrink.  Although QE3 may have some stimulating effect in the United States, it will certainly have a crippling effect in EMEs.

India has not yet been affected. In October, the inflow of FII investment has undoubtedly increased but not so much as to create exchange rate or liquidity problems. Partly, it is because the Indian economy has slowed down, the rupee has depreciated and inflation and interest rates are at their peak.

The Fed is least worried about the implications of QE3 for the rest of the world. If, however, the U.S. economy revives and absorbs the planned infusion of liquidity, the EMEs will be saved the trouble.

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