Effects of End of QE Global impact of a reduction in the $85/month bond

buying by Fed

Housing – Finance Link �  Booms and bust transmit directly to banks and financial

institutions; �  1973-1975 [UK-US] �  1991-2 End of S&L boom, insurers & banks in mortgages �  2006-2009 Repeal of Glass Steagall, disintermediation, alternative

banks originate distribute high LTV and subprime securitized loans.

�  Nominal rates rise, to counteract INFLATION;

�  BUT 2007-2009…. SOLVENCY CRISIS means interest rates have to go down to almost ZERO in nominal terms, negative in real terms. Classic Liquidity trap, case study for economics undergraduate course!

�  Credit dries up. Loans from banks SHRINK money supply by over $1.0 trillion……..

The Fed and QE

Interest rate transmission to real economy…

�  Ration cash between today and tomorrow consumption/investment, [instant gratification];

�  Prices at different times horizons, based on yield curve;

�  Marginal Productivity of investment > 1;

�  Low interest rates increase investment… But if there is massive EXCESS capacity… then cash is hoarded;

�  Wealth effect, lower rates, lower income from financial assets…. Increases net worth/liabilities;

�  Currency depreciates, but can be offset by FDI.

Because of credit default fear. Hard asset that can be moved easily and retains its value.

Why is Gold up? �  Gold price has been up dramatically

$85 billion in bond and asset purchases per month 6

US Fed Reserve

Huge growth in assets as a result of bank bailouts.

Bank of England �  Assets: (source: the Bank of England)

Interest rate concepts �  Nominal vs. Real. In the real world there is no money

illusion;

�  Which inflation rate? Headline.. All “index baskets” are constantly adjusted…

�  Zero bound nominal rates… Deflation, liquidity trap..

�  Yield curve changes affect saving investment horizions;

�  Interest rates include a element of risk premium; �  Credit; �  Risk implied in asset returns….

Risk transmission �  R = β[ 1 + Φ]

�  R = risk adjusted rate; �  β= risk weighting;

�  Φ = return on long term sovereign debt, assumed to be risk free.

�  β=1 is risk neutrality;

�  β>1 is risk aversion;

�  β<1 is risk seeking, gambling…

�  BUT!!!!!! This explanation breaks down when sovereign risk is not risk free, as we saw in the Greek crisis…..

Monetary Policy Impotence �  When 30 year treasury rates = 2.95%;

�  Lending at banks shrinks by >$1.0 trillion, Fed takes up only 0.6 of slack;

�  QE transmission out of US economy, in essence back stops growth in EMERGING markets, not US;

�  Unconventional monetary policy: Central bank can buy anything to create bank reserves, high powered money [H], [through money multiplier];

�  EFFECTS OF QE: �  Lower yield’s across yield curve; �  Lower risk premiums ~ improving liquidity; �  Increase Wealth; �  Increase Ms and H. This can increase lending but really has not as corporations

hoard cash, buy back shares.

�  REAL ECONOMY GROWTH…. It is not happening fast enough……

Hazard of large scale assets of central banks

�  International financial system stabilities, but is drugged by Ms and H from Central banks;

�  Financial assets bubble in the future? Or is it a crucial stop gap to prevent deflation… If so the financial system is inherently UNSTABLE (complex time lag);

�  Changes US $ foreign exchange rates as reserve currency and the term of trade.

Food price index up �  Food price index has been up since 2007 (Source:

Food and Agriculture organization of United Nation)

China CPI and Food Price

China CPI and Food price

0246810121416

2010-01

2010-03

2010-05

2010-07

2010-09

2010-11

2011-01

2011-03

2011-05

2011-07

2011-09

2011-11

2012-01

2012-03

2012-05

2012-07

2012-09

% CPIFood

Does QE cause inflation? Printing money causes inflation only if the money

is lent & spent …

6.50

6.70

6.90

7.10

7.30

7.50

7.70

7.90

2008 2009 2010 2011 2012

$trn

0.0

0.5

1.0

1.5

2.0

2.5

3.0Money supply(right axis)

Bank credit (left axis)

Source: Gregory Ip, Economist. Shows the extent of bank solvency problem!

… or if expected inflation rises

-1.5-1.0-0.50.00.51.01.52.02.53.03.5

2008 2009 2010 2011 2012

Expected inflation

Real bond yield

Source Gregory Ip, Economist

A lot of QE benefit swallowed up Gap between mortgage rate paid by homeowner,

and yield on mortgage bond

Source: http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf

But seems to be working

Source: Gregory Ip Economist

QE monetary policy effect on recovery

�  High food prices and high gas prices degrades developing country consumer confidences on the future

�  Appreciated currencies of emerging markets and declining demand of the western markets impeded recovering economy of emerging markets

�  Currencies appreciation/depreciation for $, Euro, Yen and C$ create new carry trades in the recovery from this five-year recession

Has QE worked? a measure of x: spread between corporate and Government bonds

Only in a temporary way But: In the long run.. We are all dead!

Conclusion �  Democracies in advanced are addicted to nominal

growth, not real growth!

�  Money supply has bought time for the adjustment in living standards;

�  Now it is up to developed world to create real economy wealth, and that is very difficult in todays economic environment;

�  Banks role at center of developed economies will have to change [= regulated], as have not been able to fund growth, just asset bubble lending.