The long awaited and big news event this week was the decision by the US Federal Reserve to launch a new program of
quantitative easing, also known as QE2. They committed to purchasing US$ 600 bn of assets (mainly government bonds), in an effort to stimulate the economy. The market response was as expected - gold and stocks went up while the dollar fell. This had already happening for some time in anticipation of this.
Let's examine some of the rationale behind the Fed's decision. What is the aim of QE? When a central bank wants to stimulate the economy it will usually lower interest rates. The rate that the Fed and other central banks have control over is the rate on overnight borrowing. Bringing down this rate is supposed reduce interest rates across the board. This should lead to more borrowing, and hence more investment and consumption to stimulate the economy. This is all well and good, but what's a central bank to do once it can't lower rates anymore?
The QE program is going to be used to buy government bonds, and in particular it will be used to buy long-term bonds. The purpose of this is to lower interest rates on these bonds, which should then feed to lower rates everywhere. Like before, the lower rates should stimulate the economy. So we can think of QE as a method by which to lower long-term interest rates.
So who are the winners and losers? QE is usually expected to result in higher inflation. Therefore, people in debt will benefit (as the real value of their debt decreases), while people with savings will suffer (as the real value of their savings decreases). Such policies are often criticized because they effectively bail out people in debt while punishing those who have been prudent with their money. This of course only affects people with savings or debt denominated in US$.
Aside from domestic effects, we know QE has a big international effect too. The biggest consequence of this policy is the weakening of the dollar. This in theory should increase US exports and reduce their imports. There has been much criticism from countries across the globe (emerging markets and developed countries) that their economies will suffer as their own currencies get stronger against the dollar.
My belief is that the Fed's real aim of QE2 is a weaker dollar (as interest rates are already low I don't believe that lowering them more will have much effect). They want the US economy to come out of its slump by exporting more and importing less. Unfortunately, most other countries want the same thing too. They all want to grow their exports and reduce their imports. It is obviously not possible for all countries to do this at the same time.
The US has one of the largest trade deficits in the world. They are frequently characterized as the consumer of last resort. Some countries are highly dependent on exports to the US, and this is one of the reasons there has been so much objection to the Fed's attempt to weaken the dollar.
While the objections are understandable, in the long run these attempts are futile. The large trade imbalances that characterize the world today are not sustainable in the long run. Deficit countries will currencies weaken and surplus countries will see their currencies strengthen. It is not a question of if, but a question of when. The answer depends a lot on political factors. Despite the short term objections to dollar weakening, I'm sure in the long term no country wants to continue the status quo whereby when the US sneezes, the rest of the world catches a cold.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!