QE: Prove It First

QE: Prove It First

By Seeking Delta of http://seekingdelta.wordpress.com

“Fed itself has admitted in the last couple days in speeches that they don’t know what they’re doing. They just hope what they’re doing works.”

~Kyle Bass of Hayman Capital 10/06/2010 via CNBC

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With talk of QE2 in full swing, I found yesterday’s comments from Goldman’s Jan Hatzius regarding NY Fed President William Dudley’s speech very interesting (emphasis is mine):

These are legitimate concerns, but they do not mean QE2 will not have an effect. As President Dudley pointed out, those who are able to borrow will do so at lower rates, freeing up some of the income now being spent on debt service. Perhaps more importantly, QE2 works on other elements of financial conditions, including equity prices and the exchange rate. To the extent these moves bolster consumer confidence, reducing the drive to boost saving, and make US goods more competitive in world markets, QE2 can work through channels other than credit.

Q: What options besides renewed asset purchases does the Fed have?

The main alternatives are to modify its communication with the markets and to tinker with its inflation objectives. Recent speeches by Fed officials have offered some ideas for consideration on both fronts. On communication, he suggested that the FOMC could be more explicit in saying how it planned to respond to shortfalls in meeting its objectives for inflation and unemployment. On tinkering with its inflation objectives (this is our term—decidedly not his!), he suggested that the Fed could, in essence, target the price level over the medium term. Thus, if inflation continued to fall short, then the FOMC would explicitly try to offset that with higher inflation later.

A few things jumped out at me in particular; in addition to lowering borrowing rates the Fed hopes to accomplish via QE2 higher equity prices, a lower exchange rate and avoid deflation with the hope these measures will spur an improvement in the real economy.

Fortunately for us we have a country that has been attempting to spur its economy via these methods for nearly a decade. Let’s take a look at how it has worked.

The first two charts are pulled from a presentation by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Second International Journal of Central Banking  Fall Conference on September 16th of this year.

central bank balance sheet
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overnight call rate

Key points to notices are the expansion, in earnest, of the BOJ’s balance sheet starting around 2001. The second point to notice is that they have managed to keep interest rates low and the QE start date of March 2001.

With this is mine, QE starting in March 2001, we look at its effects on the Nikkei index, the foreign exchange rate and inflation.

Japanese stocks
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Notice the initial rally in the Nikkei, however nearly a decade later it remains 25% below its March 2001 level.

foreign exchange rate
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Again, similar the the Nikkei, notice the initial weakening of the Yen but the long term trend continues. The dollar is currently 30% weaker versus the Yen than in March 2001.

With QE batting zero for two so far, let’s look at its impact on inflation.

japan inflation 1980-2008
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As you can see, despite its best efforts, the BOJ has been unable to spur inflation.

And lastly, just for good measure, let’s take a look at QE’s impact on the real economy by looking at GDP.

japan gdp change %
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While I understand that there are differences between Japan and the US, I also believe there are many similarities, primarily the overriding trend of deleveraging in both economies. With such a recent and similar example of another central bank using QE to attempt, and fail, to jump starting its economy I feel the onus should be on those at the Fed to prove why it will work this time before trying again here with QE2.

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