Why have central banks around the world embraced quantitative easing? Is it a necessary evil? Will it work?
The surface answer is that Large Scale Asset Purchases (LSAP), a/k/a quantitative easing, help to offset the de-stimulatory and deflationary effects of fiscal constraints within the overall thematic context of deleveraging. Debt obsession begets austerity regimes, which satisfy the politics and dogma of some (not to mention the libertarians and austerians who subscribe to the view that limited, no, or negative economic growth in the here and now will lead to positive growth in the future). Therefore, the only easily accessible (and largely non-political and controllable) public policy tool in the toolbox is easy money. That's the surface reason why. But what underpins this thinking? What is the foundation upon which LSAP/QE is believed to work? For that, I present the following three quotes* from Milton Friedman and Anna Schwartz, Ben Bernanke, and Joseph Gagnon et. al, respectively, and thereby, introduce some (most?) of you to the concept of the portfolio-balancing effects.
"It seems plausible that both nonbank and bank holders of redundant balances will turn first to securities comparable to those they have sold, say, fixed-interest coupon, low-risk obligations. But as they seek to purchase these they will tend to bid up the prices of those issues. Hence they, and also other holders not involved in the initial central bank open-market transactions, will look farther afield: the banks to their loans; the nonbank holder, to other categories of securities – higherrisk fixed coupon obligations, equities, real property, and so forth…
As the prices of financial assets are bid up, they become expensive relative to nonfinancial assets, so there is an incentive for individuals and enterprises to seek to bring their actual portfolios into accord with desired portfolios by acquiring nonfinancial assets. This, in turn, tends to make existing nonfinancial assets expensive relative to newly constructed nonfinancial assets. At the same time, the general rise in the price level of nonfinancial assets tends to raise wealth relative to income, and to make the direct acquisition of current services cheaper relative to the purchase of sources of services. These effects raise demand curves for current productive services. The monetary stimulus is, in this way, spread from the financial markets to the markets for goods and services.'
Milton Friedman and Anna Schwartz
"I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which hold that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of assets held by the public."
"These portfolio-balance effects should not only reduce longer term yields on the assets being purchased, but also spill over into the yields on other assets. The reason is that investors view different assets as substitutes and, in response to changes in the relative rates of return, will attempt to buy more of the assets with higher relative returns. In this case, lower prospective returns on agency debt, agency MBS, and Treasury securities should cause investors to seek to shift some of their portfolios into other assets, such as corporate bonds and equities, and thus should bid up their prices. It is through the broad array of all asset prices that the LSAPs would be expected to provide stimulus to economic activity. Many private borrowers would find their longer term borrowing costs lower than they would otherwise be, and the value of long-term assets held by households and firms — and thus aggregate wealth — would be higher."
Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack
Investment Strategy Implications
The justifications for the extraordinary actions being undertaken by central banks around the world are clear. The obvious need to offset the negative effects of other public policy actions leaves it almost exclusively up to the central banks to fulfill their mandates and, in the process, avoid global chaos and, hopefully, produce the eventual goal of a sustainable economic expansion (not recovery but expansion). The central basis upon which this course of action is taken is that the desired economic outcomes will occur largely via the portfolio-balancing effects. Talk about standing the global economy on the head of a pin.
Will it work? What are the related consequences and issues involved? What are the other forces at work? And what does it mean for the financial markets and investment decision-making?
In next week's installment we will take that into consideration.
*Many thanks to Professors David Beckworth and Joshua R. Hendrickson for their excellent and clearly articulated descriptions and quotes. To view their full report, click here!
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Thursday, May 16, 2013