By Abhishek Gaurav
Edited by Namitha Sadanand, Senior Editor, The Indian Economist
No other monetary policy has received as much attention as the unprecedented scale of quantitative easing adopted by the Federal Bank of the U.S.A. in the wake of the recession to spur investments and growth in the ailing economy. An obvious question that arises is, whether such an unconventional tool to resuscitate the economy was required, and whether we would ever be able to adjust to an economic paradigm devoid of this monetary pill.
In the financial year 2007-08, the U.S. economy was headed towards the worst economic crisis since the great depression of 1929. The asset market was crumbling, banks and financial institutions were going bankrupt overnight and the investor confidence had touched a new low. Suddenly, the onus was on the Feds shoulders to avoid the ignominious collapse of the financial markets. And, as they say, desperate times call for desperate measures; the Fed did rise to the occasion and conjured up an unprecedented policy, which was unmatched both in terms of scale and its potential impacts.
Till the onset of the full blown crisis, the Fed was conducting its policies under a federal funds rate strategy wherein it targeted a particular rate for a short duration of time. Other monetary aggregates like money supply became secondary to the interest rates. The benefit of adopting such a nominal anchor is that investments can then be directly regulated, given the negative relationship running between investments and interest rates. The problem arose in the summer of 2008, when in an effort to reverse the economic downturn; the Central Bank had to reduce the federal funds rate nearly to zero. This is the effective lower bound for any nominal interest rate, and thus then on, the Central Bank could not have spurred investments further, by simply lowering the rates. In response to these unusual developments, by late-2008, the Federal Reserve came up with its own set of unconventional monetary policy instruments which included large purchases of mortgage backed securities, long term bonds and commercial paper. Other initiatives included providing loans to hedge funds and other investment firms that were furnishing credit to the critical sectors of the economy like student, auto and home loans, and others that could have slowed down due to shortage of funds from the banks. Taken together, these measures are popularly known as quantitative easing.
As part of this process, the Federal Reserve’s balance sheet swelled from approximately $800 billion pre-crisis levels to nearly $4.5 trillion currently, by continuously buying mortgage backed securities and other treasury securities. The interesting aspect about quantitative easing, however, was that the Central Bank did not print currency to furnish the requisite credit to the banks, but simply used its authority to expand the reserves of the private banks with it. Consequently, banks had fewer loans to meet and could readily lend cash to businesses. Now that the Federal Open Market Committee (FOMC) has decided to end the bond-buying programme at its meeting on 28-29th October, a detailed scrutiny of its reverberations in the financial industry is bound to follow. Nobody can deny that quantitative easing has altered the rules of finance and markets. The question is, to what extent?
To cite a few of its consequences, quantitative easing has resulted in a stronger US market with a sustained bull phase in stocks since March 2009. As per a report of Wyatt Investment Research, the stocks have risen as much as 79.5% in the period of fed bond-buying program.
The S&P 500 index, which was gasping for breath at 700 in late 2008, has touched new highs of 1900, resulting in the nearly tripling of stock values. The Fed also succeeded in keeping the long term interest rates low which were deemed essential to rejuvenate the critical sectors of the economy. The low interest rates have been a major contributor to the boosting of GDP levels from a low -2.8% in 2009 to 1.9% last year. This surge in GDP to pre-crisis levels, fuelled by consumer spending, is viewed by many as the success of quantitative easing program. The unemployment rates, too, have gone down from a high of 10% in October 2009 to as low as 5.9% in the last month, September 14. However, an interesting thing to note here, is that though the unemployment rates have taken a historic dip, inequality has been rising at alarming rates. The wealthy 5% in USA today govern more than 63% share of the total wealth; with their average real wealth rising from $3.6 million to $6.8 million in a period of 25 years. As opposed to this, the lower half of the income distribution has shown worse outcomes, with one-fourth of them reporting negative net worth in the same period.
Thus, quantitative easing may have added the fizz that the markets needed just after the crisis. But one wonders whether all of this good work will fizzle out quickly, once the markets are left to themselves. Signs of catastrophe could be seen last week itself when on 15th October, Dow Jones stocks tumbled by more than 3% during the day. Amidst rising concerns of a second worldwide economic disaster, it remains to be seen whether quantitative easing has, indeed, made the economic framework more robust and most of all, whether we can do well without it.
Abhishek Gaurav is a B.S. M.S. dual degree student in Economics at IIT Kanpur. He has a prior experience with the development economics centric research arm of MIT, Abdul Latif Jameel Poverty Action Lab (J-PAL), primarily working in the area of evidence based policies. His interests lie at the intersection of economics, politics, policy and finance. He can be reached at: abhishekgaurav001@gmail.com.