Quantitative Easing - Decreasing Interest Rates - Research Paper Example

Quantitative Easing / Decreasing Interest Rates Introduction Quantitative easing is referred to an unconventional monetary policy practiced by central banks to enhance the growth rate of an economy when conventional monetary policies fail to stabilize and stimulate the economy. As Bonner, Wiggin, and Incontrera (2009) point out, through quantitative easing, a central bank generally purchases different types of financial assets to pump a fixed volume of money into the economy with intent to promote economic activities and thereby to boost growth rate (p. 272). This practice is entirely different from the usual approach of purchasing and selling government bonds to maintain a targeted market interest rate. It must be emphasized that a central bank uses new electronically created money for the purchase of financial assets in order to implement quantitative easing policy. This practice is helpful for increasing excess bank reserves which in turn may lower yields. The ultimate goal of the quantitative easing policy is to cut down long term interest rates so as to stimulate economic activities. For this purpose, monetary authorities purchase financial assets of longer maturity and thereby reduce long term interest rates on the yield curve. In addition, the tool of quantitative easing is very helpful to ensure that inflation rate does not fall below the targeted level. This paper will analyze the pros and cons of quantitative easing and will discuss whether the Fed has a choice of using this tool in a highly recessionary economy. Benefits of Quantitative Easing As Elliott (2009) purports, the unconventional quantitative easing monetary policy may assists banks to keep excess reserves with them and hence to lend largely to businesses and individual borrowers. In turn, businesses will use these additional funds to finance productive activities including infrastructure development and R&D. Similarly, individual borrowers will use this new fund for their day to day activities or investment purposes. This will ensure effective circulation of money throughout the economy. Hence, these increased economic activities will certainly assist the economy to come out of stagnation and stimulate economic growth. Since this monetary tool is helpful to keep the inflation at a moderate level, it assists regulators to prevent the economy from falling into deflationary conditions. According to Kollewe (as cited in the guardian, 2009), US, UK, and Japan are very much interested in quantitative easing policies as a way to stabilize economic growth. The writer points out that the US was the first country which used quantitative easing as a response to its recessionary conditions. According to International Monetary Fund, the major developed countries that deployed the quantitative easing policy since the beginning of the 21st century were less affected by the 2008 global financial crisis as compared to other industrially developed economies. During the 2008 global financial crisis, it has been identified that the quantitative easing boosted the financial markets by adding liquidity. A weaker currency that amplified export demand is also identified to be one of the major desirable side effects of quantitative easing policy. To a certain extent, the quantitative easing technique has assisted economies to diminish unemployment rate. While analyzing the US economy, it is obvious that this unconventional monetary tool has played a crucial role in the economy in overcoming the dreadful impacts of the 2008 global financial crisis. As per the report of Hermansson (2010), economists hold the view that US’ entire budget deficit would be funded for a fiscal year, if the quantitative easing has been set as high as $1 trillion. In order to take advantages of the quantitative easing policy, the Fed used the returns of previous bond purchases to acquire new long term financial assets in 2010. In addition, this policy has greatly assisted the US economy to maintain inflation levels. Demerits of Quantitative Easing Although this tool may aid a stunted economy to spur its economic activities, it will produce some adverse impacts once the theoretical assumptions go wrong. To illustrate, as Harrison (2011) points out, quantitative easing may sometimes lead to higher inflation if too much money is created as a result of overestimation of easing amount. Similarly, banks may use the surpluses to make investments in emerging markets or to exploit non-local opportunities instead of allowing credit to local businesses. Therefore, if banks remain reluctant to credit giving regardless of its excessive reserves, there would not be effective circulation of money and this situation may ultimately lead to the failure of the quantitative easing policy. Some of the economists strongly claim that lower interest rates would cause asset bubbles in other economies in a global context although this argument has not attained considerable attention. It is clear that an increase in production in an economy as a result of excessive money supply will directly lead to a subsequent increase in the value of a unit of currency. However, central banks have the option of withdrawing the excess money from the market through raising interest rates during the times of high economic output. Such a situation may effectively reverse the easing steps taken by the central bank. According to Inman (as cited in the guardian, 2011), while increasing the money supply as part of the quantitative easing policy, it may adversely affect a country’s currency exchange rates. The negative feature of this tool directly benefits exporters who reside in the country and debtors whose debts are valued in that currency. In contrast, this situation hurts the interests of creditors and other currency holders because the real value of their holdings are diminished. The currency devaluation also causes troubles to importers as this situation inflates the cost of imported goods. In the opinion of Hermansson (2010), although the quantitative easing approach works effectively at the peak stage of a crisis, it has only a little role to play when recovery is in progress. Risk levels to a central bank significantly increase when the bank switching its focus from short term securities to long term securities. In addition, when a central bank purchases various financial assets, it disrupts the flow of financial market and compels players to be dependent on the policy changes of the bank. In certain situations, the quantitative easing strategy may also raise threats to the independence of the central banks. Risks of Flooding the Market with Money The US economy floods the market with money as a measure to overcome the impacts of the 2000 global financial crisis and subsequent bank collapses. From the view point of Kollewe (2009), it is identified that this monetary policy does not really benefit the Fed even though this approach may bring notable achievements in the short term. According to Kurtz (2011), CIO of RK Investment Advisors, LLC, “Don’t fight the Fed” is the theme of the last two years. Even in the face of bad news, when the Fed floods the market with money, stocks rise, and when the Fed stops, the market falls” (Business Wire). Although US stocks dramatically rose due to the injecting of a trillion dollars into the market, the market dropped 18% by the end of the Fed’s first round of quantitative easing. In addition, the excess money by the Fed depreciated the value of the US dollar against other currencies. This situation extremely affected the US financial markets and other productive sectors of the country. As Wolverson (2011) reports, China held foreign reserves of $3.26 trillion in the US treasuries as of August 2011. This huge figure indicates China’s enormous growth in the US dollar holding over the past decade. The gigantic Chinese reserves in the US treasuries today threaten the financial viability of the United States. Suggestion for the US Economy It is too late for the US economy to search another option for surviving the recessionary conditions since a sudden stoppage of money supply into the market may lead to the total collapse of the economy. Furthermore, a best alternative monetary policy is not currently available for the Fed because the excess money supply into the market over last few years has worsened the economic condition of the country. Therefore, continuation of the quantitative easing approach would be the best fitting monetary policy for the Fed in the current situation. However, the regulators must be vigilant to ensure that the excess money is being effectively circulated across the market. For this purpose, the Fed has to encourage the US banking sector to provide extensive credit facilities to the country’s businesses and citizens. At the same time, the country must eventually try to reduce the amount of money supplied to the market so as to stabilize the economy. Anyhow, the US economy will take more time to survive the highly recessionary conditions and to come to a sustainable growth track. In other words, there is no scope for the US economy to achieve success in short term. Conclusion In total, quantitative easing is an effective monetary policy to maintain lower interest rates and thereby to promote rapid economic growth provided that the theoretical assumptions are accurately met. In contrast, quantitative easing approach may severely affect the economy’s development if the assumptions go wrong. The practice of flooding the market with money involves a lot of risk elements as it would threaten the sustainability of the economy. However, it is advisable for the US to continue the quantitative easing policy since the economy is not in a position to adapt to another monetary approach. References Bonner, W., Wiggin, A & Incontrera, K. (2009). Financial reckoning day fallout: Surviving today's global depression. US: John Wiley and Sons. Elliott, L. (2009). Bank of England extends quantitative easing to £200bn. The Guardian. Retrieved from http://www.guardian.co.uk/business/2009/nov/05/quantitative-easing-25-billion-pounds Harrison, E. (2011). The Federal Reserve’s Quantitative Easing is Raising Inflation Expectations. Credit Writedowns. Retrieved from http://www.creditwritedowns.com/2011/02/federal-reserve-raising-inflation-expectations.html Hermansson, C. (02 November, 2010). To the point: Central banks face difficult choices. Swedbank, 1-7. Retrieved from http://www.swedbank.se/idc/groups/public/@i/@sbg/@gs/@corpaff/@pubaff/documents/publication/cid_168352.pdf Inman, P. (29 June, 2011). How the world paid the hidden cost of America’s quantitative easing. The Guardian. Retrieved from http://www.guardian.co.uk/business/2011/jun/29/how-world-paid-hidden-cost-america-quantitative-easing Kollewe, J. (05 March, 2009). Bank of England cuts rates to 0.5% and starts quantitative easing. The Guardian. Retrieved from http://www.guardian.co.uk/business/2009/mar/05/interest-rates-quantitative-easing Kurtz, R. (11 October, 2011). RK investment advisors speculators portfolio up 142% in Q3. Business Wire. Retrieved from. http://www.businesswire.com/news/home/20111011006254/en/RK-Investment-Advisors-Speculators-Portfolio-142-Q3 Wolverson, R. (02 November 2011). Confronting US- China economic imbalances. Council on Foreign Relations. Retrieved from. http://www.cfr.org/china/confronting-us-china-economic-imbalances/p20758#p2 Read More