Quantitative easing for dummies

I went for a very interesting session yesterday –the effects of quantitative easing and a zero interest rate policy on the currency markets. Before I get to my key take-ways from the session, here are a few basic inputs.

What is quantitative easing?

Yes, it is the creation of new money. However the manner in which the exercise is undertaken is interesting. It is essentially the open market operations of the central bank i.e. the central bank buying back government bonds from the holders such as banks etc, thus, creating a flow of money in the system. It could also be lending more money to deposit taking institutions or buying assets from banks etc but for the moment we will stick with the first. After all, that is what we are seeing in UK at the moment.

Why does a central bank need to undertake quantitative easing?

When there is a slow down in the economy or even a recession, the first step of an efficient monetary policy would be the reduction of interest rates. This would be aimed at reducing savings and increasing investment and demand. However, in severe cases, the government would reach close to zero interest rates, in which case, interest rate manipulation to ease recessionary impacts in the economy is no longer a tool - which is when QE comes into play.

And now for the some of the highlights from yesterday:

On QE:

· Increasing the supply of money isn’t necessarily a bad thing if inflation is under control and in fact, the central bank is anticipating deflation i.e. evaluate the motivation of the central bank

· To measure the impact on currency, the credibility of the central bank will come into play. With lack of credibility, the money generated will tend to be invested abroad in safer havens and currency will depreciate. However, when central banks are buying gilts, bunds, t-bills in an uncertain environment and there is repatriation of money i.e. banks, FI’s continue to bring their investments home, the government still has credibility and currency will appreciate i.e. monitor the perceived credibility of the central bank

· The impact of QE needs to be considered with a broader macroeconomic perspective - a measure is the CDS spread. If QE makes default seem less likely, CDS spreads will reduce which is a positive for the currency i.e. assess the context in which the central bank is undertaking QE

On ZIRP:

ZIRP may not be a bad policy; it is the anticipated change in the interest rate policy which has an impact on currency movements.

And finally a few examples with some of the interesting points made. I still need to absorb all of this but as I understand it: QE is undertaken not just to stimulate growth and inflation but also to weaken a currency.

New Zealand was quoted as an example of a country which will not undertake QE so as not to weaken the currency any further. Why - because they are a net debtor and not a net creditor. Since they need to fund their current account deficit, the will need to buy fixed income securities of other governments and hence they already have a weakening currency.

The US, on the other hand, has a huge debt deficit but has surplus equity investment. Hence when they undertake quantitative easing, the dollar strengthens.

Japan was another example of a country which has next to zero interest rates and then undertook QE to weaken their currency and stimulate exports.

And finally Switzerland: the best recent example http://www.snb.ch/en/mmr/reference/pre_20090312/source/pre_20090312.en.pdf - an excellent explanation