The Federal Reserve has extend its quantitative easing, now dubbed as QE2, by announcing that it will print $600 billion to purchase longer term government securities . The Fed has experienced some success from using its QE1, although limited, which came in the form of stabilizing the economy by helping pulling it out of its worst recession since the Great Depression. After trying the unconventional monetary policy, known as QE1, the Fed while constrained by the zero interest rate bound is trying again to use the same remaining economic weapon in its areal. However, this time QE2 is somewhat different from QE1 in two aspects. First, while QE1 included purchasing government and mortgage-backed securities with a primary aim of targeting short-interest rates and the housing sector, QE2 concentrates on buying long-term government securities with a crucial objective of influencing the long-term interest rate which is greater than zero. Here the target is to stimulate business investment and reflate assets prices. Second, while QE1 announced a specified size of printed money that was exchanged for the securities, QE2 would use a gradual, formatted approach with buying the government securities. In this case, the Fed would be in better command in managing inflationary expectation and later in pursuing an exit strategy than in the case of another QE1. This kind of approach commands more consensus at the FMOC than the first one.
I believe QE2 like QE1 would still have limited success, since the Fed is overcautious in its purchase installments from the deep and the vast government securities market. The QE channels under zero interest rate bound are narrow and may have dead ends. This means in a liquidity trap, monetary policy is not effectively connected to economic activity. A detailed examination of those channels may help explain the existing disconnects between the monetary policy and economic activity in a liquidity trap and why QE2 is also likely to have limited success. It may also help in pointing out which channel is the most favorite to the Fed.
1. The Bond Channel
The Fed has announced its intentions to buy US Treasury bonds to nudge the long-run interest rate lower, which is in sequence leads to lower real interest rates and lower cost of borrowing for businesses. Under normal conditions, lower real interest rates should positively influence capital investment and help stimulate the economy. But Professor Alan Blinder, a former deputy chairman of the Federal Reserve, in a recent article published by The Wall Street Journal contents that there would be a slippage between changes in the government bond rates and changes in the corporate bond rates to the point that the latter will not command much impact . This means that this channel is narrow in its efficacy. Moreover, Professor George Stiglitz, a noble prize laureate, in a recent blog post raised the possibility that if the interest rate channel succeeds in stimulating economic activity, it would raise expectations of higher short-run rates, which in sequel contributes to higher long-run rates . In fact, the yield on long term bonds have started to rise based on the expectations that QE2 is coming. In this case, the interest rate channel could have a dead end.
2. The Mortgage Channel.
It is true that actual QE1 and the expected QE2 have contributed to lower mortgage rates but the effect of this policy t has not reflected positively enough on the housing sector. Under the liquidity trap, the mortgage channel is very narrow and may even have a dead end. House prices have not moved up as sales of new and existing and new homes are now less than they were during the last decade because of strict qualification standards and highly leveraged households. Moreover, the published low mortgage rates are not available to all borrowers as more risky mortgage seekers have been priced out of the market by higher rates. Those who qualify for the published lowest rates would need a credit score of 740, but those with a score of 600 (and there are plenty of them) find that conventional loans are not available to them at any price . Loans provided under the Home Affordable Refinance Program (HARP), which was designed to make refinancing possible for underwater borrowers who are current on their payments and whose loans are owned by Fannie or Freddie, that have a loan-to value (LTV) ratio that exceeds the 125% maximum are rejected. There are millions of mortgage borrowers who have taken loans under HARP. To these people with the lower score and the higher than the 25% LTV maximum, the mortgage channel has a dead end.
3. The Equities Channel
This is based on the "portfolio balance theory" and is probably the most important channel in the Fed’s calculations under the current liquidity trap constraint. The Fed is obviously using this channel to magnify two effects: the consumer confidence effect to make the consumer (70% of the economy) spend more, and the wealth effect through inflating asset prices to make the consumer buy more expensive goods. The Fed wishes to boost these two effects to compensate for the very feeble interest rate effect. The stock markets are responding very well so far but the consumer is showing meager increases in confidence. The value of households' stock holdings is about $ 7 trillion at today's prices. Significant increases in the sock prices should have greater effect on wealth and consumer confidence effects than smaller rebounds. But we do not know how high equities prices should rise for this channel to work successfuly.
Large companies have shown recently to be profitable, probably because of boosting productivity and profiting from the government’s stimulus package in paying off long-term debt and acquiring other companies cheaply. Despite the fact that these large companies are flushed with cash, they do not find it profitable to invest in plants and equipment. According to Moody’s Investors Service, large U.S. companies are hoarding almost $1 trillion of cash, a number that has increased considerably over the last three years. Cisco Systems Inc., Microsoft Corp. and Google Inc. account for the biggest portion of the $943 billion stockpile. Currently, U.S. companies have a cash-to-capital expenditures ratio of 1.64 times, possibly an all-time high and higher than the 1.1 ratio that prevailed in December 2008. It is highly likely that the increases in equity prices of U.S. companies do not reflect higher profits resulting from strong business activity growth but from the weakening of the dollar which comes as a sequel to quantitative easing. On the other hand, small and medium sized enterprises (SMEs) are credit-constrained and unable to hire. They recent drop in commercial properties and maybe stock prices have made their collaterals low which is an important ingredient of their qualifications to access credit from the capital markets.
But here comes the wealth effect that is hoped to work through rebounding asset prices. It will be interesting to see if this channel, on which the Fed has hung its hopes the most, will work with some lags. But for now, this channel is also closed as the wealth and consumer confidence effects are not leading to increases in economic activity.
4. The exchange rate channel.
It seems that all countries are inclined to resort to competitive devaluations and/or currency controls as a way to keep their currencies undervalued in order to stimulate exports and the economy. But beggaring neighbors through devaluations will not be effective if the devaluations are serial and competitive. This is a protectionist tool that reduces the volume of global trade and can lead to a global recession at best. But this tool combined with the assets price-induced wealth effect has a better chance to influence economic growth.
Overall, QE2 is more constrained than QE1 and its success will also be helpful but limited. Its channels are either narrow or have dead ends under the current liquidity trap. The Fed’s forthcoming gradual approach should be long, patient and suitably sizable to bear more fruits. The wealth effect figures highly in QE. The implementation and administration of tool is as good as the tool itself.
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