QUANTITATIVE MONETARY EASING: The history and impacts on financial markets By Abdulmalik Oricha Ali (1300348) Candidate: Chartered Islamic Finance Professional (CIFP) INCEIF – The Global University of Islamic Finance Contents Abstract ......................................................................................................................................................... 2 Introduction ................................................................................................................................................... 2 1. History............................................................................................................................................... 5 2. Transmission mechanism ................................................................................................................ 10 3. Discussion: impacts of quantitative easing on financial markets .................................................... 13 References ................................................................................................................................................... 15 Abstract Quantitative monetary easing, as defined throughout the light literature on the topic refers to unconventional monetary policies employed by National Central Banks, to stimulate economic growth when conventional or standard monetary policies prove ineffective. The application of these specific genre of monetary policies has been during major recessions or economic stagnation such as; the great depression of 1929, the Japan financial crisis in the 90s, and indeed the recent Global Financial Crisis of 2008. This paper is an attempt to explore the history of quantitative easing as an unconventional monetary policy, to explain some of the major positive short term effects and indeed the more precarious long term effects on financial markets. It is our opinion that quantitative easing, when applied discreetly during recession, and not in cover of financial recklessness of mega corporations or governments, can indeed spur economic growth by rechanneling funds to the desired sectors of the economy. However, indiscrete applications have the potential to throw economies into hyperinflation. Introduction The world is truly globalized and has always been. The advent and development of technology has only helped to hasten the process. The historical prominence of matters such as international trade alliances and treatise, currency and financial markets inter-linkages, have served to ensure that there are always dependencies between these factors and popular economic indicators such as; gross domestic product (GDP), unemployment rate, foreign trade, exchange rates, wholesale commodity prices etc., both in third world countries, middle income (developing) and the often called developed countries. The difference between these group of countries being, according to (Bell & Pavit, 1993), rooted in the level of industrialization, permeation of technological innovation and standard of living. That said, it is noteworthy that regardless of the country, the national central banks (mostly the Apex bank) in these countries react to strains in any of the matters mentioned earlier in very predictable ways and using know economic tools. An instance for illustration would be the US Federal Reserve or the Bank of England reacting to sudden spikes in market interest rates1. These often short term events manifest in the form of commercial banks and other financial institutions lending to customers2 at higher interest rates which in turn sets off a chain reaction of other short term events such as; an increase in cost of business and trade, rising cost of commodities, and middle to long term events including rise in the cost of variable rate mortgages, and a general drop in consumer spending. Traditionally, the market interest rates, often the major precursor of these events, are to a large extent dependent on the prevailing official interest rates and other policies set by the Central Banks. This leaves the Central Banks with the leverage to adjust at will, prevailing market conditions. The Central Banks carry out this quintessential task using three major policy mechanisms all of which are discussed in subsequent sections of this paper. They include the Open Market Operations, Discount rate (Official interest rate) setting, and Reserve Ratio setting. Together all these policies have come to be known 1 Rates at which commercial banks lend to other sectors of the economy such as governments, agencies, the private sector, households both locally and internationally 2 Households, businesses, other banks and financial institutions, government agencies etc. as conventional monetary policies (INVESTOPEDIA, 2013; Joyce, David, Scott, & Vayanos, November, 2012) On the other hand however, in extreme situations such as economic meltdowns, systemic failures and depressions, the aforementioned policy mechanisms have so far proven to be at best ineffective, to the extent that the interest rates approach the zero bound level; a concept that would also be touched on in the latter parts of the paper. Historically, stemming these daunting challenges have been approached by various national (US, Japan, Argentina, Zimbabwe, Nigeria) and regional governments (European Community) using very different and relatively peculiar policies mechanisms referred to in literature as unconventional policies (Joyce, David, Scott, & Vayanos, November, 2012; Cúrdia & Woodford, 2009). Quantitative easing (QE) comes across as one of these. Others include, Operation twist and credit easing (United States), which is mechanically equivalent to QE but goes a step further to restructure the asset composition of Central Banks to influence market conditions. This report is entirely dedicated to explaining quantitative easing from a historical point of view, and to analyzing the historical and possible future impacts of these unconventional policies on the global financial markets. The first section examines the history of quantitative easing as a policy highlighting the different cases and countries where it has been applied. In the second section, we explain in detail the concept of transmission mechanisms in relation to quantitative easing schemes and discuss different case studies in the history of QE application, their short and long term impacts as recorded in literature. In the third section, we discuss some of the adverse effects of unrestricted quantitative easing on foreign debt (especially of the US) and the tendencies to spark currency and trade wars and ultimately another global crisis in the future. We conclude the discussion with clear opinion on quantitative easing as a monetary policy 1. History Conventional monetary policy mechanisms such as those listed in the introductory chapter; the Discount rate, Reserve Ratio, and Open Market Operations, are often used to stem short term market events. These include sudden spikes in interest rates or decline in economic growth figures. However, in very extreme and sometimes more long-lasting circumstances such as post war situations, financial meltdowns or economic stagnation. There is quite a lot of historical and empirical evidence to suggest that the commonplace policies have not been sufficient. These extreme periods are usually characterized by sever decline in economic activities in the affected economy (ies), low aggregate demand, a reduction in tax revenues for the government, unemployment, sever declines in consumer spending etc. At the start of these recessions, governments through their national central banks traditionally deploy conventional techniques to lower the official interest rates in an attempt to encourage borrowing and investments of capital. Interest rates however are bounded by the zero lower baseline principle for nominal interest rates, even though a few reports suggest that Denmark actually tried negative interest rates (Joyce, David, Scott, & Vayanos, November, 2012), what is easily comprehendible in simple words is that – the least a financial institution can go in terms of intermediation is offering an amount of money today for the same amount on a future date (Zero interest). That said, it is noteworthy that in some of the major landmark economic crises that have hit certain countries and globally in other cases, manipulating interest rates downwards to low levels not immediately turn off the heat of the crisis. In these instances, the invention of somewhat more sophisticated and less commonplace policies as the quantitative monetary easing have been implemented. Quantitative monetary easing or simply QE is not entirely a new policy mechanism. Some well-grounded arguments, posit that it is a fairly well established mechanism with a traceable history that dates back to the 18th Century (Trefgame, 2012). The mechanism has gradually matured from its very simple beginnings as simply “printing money” to the more sophisticated forms that exist today as the US Federeal Reserve’s Credit easing mechanism which aims at composing the different elements of the bank’s balance sheet to meet certain economic goals. Contrary to Trefgame’s position (Trefgame, 2012), in the research work for this paper, we identified the earliest account in history of printing money (or Quantitative easing), to actually have actually come far before the 18th Century. The first recorded case being the Ottoman monetary crisis in the second half of the 16th Century. In 1585-8, the Ottoman silver currency, the akçe, was officially devalued by 100% against the Venetian gold ducat and foreign silver currencies, and its silver content was reduced by 44%. The empire had come under severe economic stagnation (Tezcan, 2009) which historians attribute to the ongoing wars with the Safavids of Persia (modern day Iraq) at the time. The next account of quantitative easing recorded was in 1797, a time known as the Restriction Period when Great Britain was engaged in war with the Revolutionary France. According to (Trefgame, 2012), in 1797, a brigade of Frenchmen, 2000 strong undertook the last invasion of Britain. William Pitt the Younger, was anxious to stop the public from redeeming paper money for gold, which had been used to fight the war against France and to subsidize Britain’s Continental allies. This led to the passage of Bank Restriction Act enacted by the Parliament of Great Britain exonerating the Bank of England from converting notes to gold. This period lasted until early 19th century. By the end of the war in 1814, the banknotes had a face value of 28.4 million pounds of gold, yet was backed by only 2.2 million pounds of gold (Wikipedia, 2013). Another instance recorded was the banking crisis of 1825. This feat popularly referred to as the panic of 1825 saw the precipitation of about 70 banks in the UK and abroad. Economists argue that the major cause of the panic was heavy speculation on bonds from the then emerging markets in Latin America. It is interesting to know that in the heat of the crisis, the Bank of England had printed surplus notes in an attempt to save the first seven main banks that later collapsed. The First World War in 1914 was another period, the Stock Exchange was closed for several days and there was a series of capital controls to steer investment into the war effort which led to the Bank of England’s decision to again initiate a quantitative easing scheme or simply to print money. In the US, a few economists agree the first quantitative easing scheme happened post 1929 during the years of the great depression. In 1932, with congressional support, the Fed purchased approximately $1 billion in Treasury securities (half, however, was offset by a decrease in Treasury bills discounted at the Reserve Banks). At the end of 1932, short-term market rates hovered at 50 basis points or less. Quantitative easing continued during 1933-36.” (Richard, 2010). In the latter decades after the Second World War (1945), the US and indeed the global economy experienced unprecedented tremendous growth and hardly was there a need to introduce such unconventional policy mechanisms. However, quantitative easing reemerged again in Japan during the crisis of the early 2000s. The Bank of Japan (BOJ) had over four years employed a series of quantitative easing schemes in an attempt to fight domestic depression. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess money and therefore little risk of a liquidity shortage (Wikipedia, 2014). The BOJ accomplished this by buying more government bonds that would be required to set the interest rate to zero. It later also bought asset-backed securities and equities and extended the terms of its commercial paper purchasing operations. It is has been reported that the BOJ increased the commercial bank current account balance from ¥5 trillion to ¥35 trillion (approximately US$300 billion) over the four- year period starting in March 2001. The BOJ also tripled the quantity of long-term Japan government bonds it could purchase on a monthly basis. More recently, we have seen very aggressive applications of quantitative monetary easing in the United States, the United Kingdom and the Eurozone. The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the recession. In late November 2008, the Federal Reserve started buying $600 billion in mortgagebacked securities. By March 2009, it held $1.75 trillion of bank debt, mortgage-backed securities, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted temporarily in June 2010 as the economy appeared to have started an upward growth trend. The US Federal Reserve however, resumed asset buying about three months later, as figures emerging indicated lean economic growth. After the halt in June, holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Federal Reserve then revised its goal to keeping holdings at $2.054 trillion. To maintain that level, the Fed bought $30 billion in two- to ten-year Treasury notes every month. In November 2010, the Fed announced another round of quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011. This would come to be known by most economists as QE2, especially the ones who do not see the earlier post-great-depression application as explicitly quantitative easing. On the 13th of September, 2012, the Federal Reserve announced a third (or fourth in my opinion) round of quantitative easing. In an 11–1 vote, the Federal Reserve decided to launch a new $40 billion per month, open-ended bond purchasing program of agency mortgage-backed securities. Additionally, the Federal Open Market Committee (FOMC) announced that it would likely maintain the federal funds rate near zero at least through 2015. A feat claimed to be effectively a stimulus program aimed to relieve $40 billion per month of commercial housing market debt risk. Because of its open-ended nature, QE3 has earned the popular nickname of "QE Unlimited." On 12 December 2012, the FOMC announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month. On 19 June 2013, Ben Bernanke announced a "tapering" of some of the Fed's QE policies contingent upon continued positive economic data. Specifically, he said that the Fed could scale back its bond purchases from $85 billion to $65 billion a month during the upcoming September 2013 policy meeting. This did not happen however until December (US$ 10 Billion) and January 2014 (another US$ 10 Billion). He also suggested that the bond buying program could wrap up by mid-2014. Though the Federal Reserve under Janet Yellen (the new Chair) announced after the recent FOMC meeting in March 2014, a further scale down of US$ 10 Billion in bond buying (Sharf, 2014), it remains to be seen if the program would be wrapped up by mid-year of if there would be a sudden twist of events since the program remains openended. In England, the recent quantitative easing scheme started in March 2009, post the collapse of Lehman brothers. The scheme, initiated by the Bank of England, focused on purchasing UK gilts3 from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies. It lasted for about three years in which a total of about 375 billion pounds was spent (Blog, 2012). The European Central Bank (ECB), even though transcending their mandate, also applied quantitative easing to a large extent between 2009 and 2012. The schemes by the ECB were specifically focused on purchases of Italian and Spanish debt. By May 2010, bank had had debt from these otherwise failing economies to the tune of about $200 billion (Blog, 2012). In addition, part of the newly printed money was also used in financing the ECB’s subsequent Long-Term Refinancing Operation (LTRO) to banks in these distressed European Countries. The loans were low- 3 UK government bonds interest-3-year-facilities collateralized with loan portfolios from obligor banks – an alternative and longer route to debt purchase in my opinion. Having recounted the history, both past and recent, of quantitative easing (QE), it is worthy of note that in the last year (2013), we have seen a major QE announcement to the tune of $1. 4 trillion by the Bank of Japan in April 2013. A question to ask at this point is how these monies (either manually or electronically printed) find their ways into the economy (Stewart, 2013). The next chapter gives a conceptual explanation of the process often known as the transmission mechanism. 2. Transmission mechanism Monetary policies by National Central Banks work via their effects on aggregate demand in the economy. In the long run monetary policies determine the value of goods and services or in other words the value of money. It therefore becomes necessary to examine the mechanism by which these policies affect the financial markets. Prior literature on the subject such as (Kuttner & Mosser, 2002) and (MPC, Bank of England) both suggest three major channels in the transmission process of monetary policy regimes. These include; the interest rate channel, the wealth channel and the exchange rate channel. A change in the official interest rates – or fed funds rate as it is otherwise known in the US, directly impacts the short term cost of capital – essentially the rates at which banks lend to clients which include the firms, consumers and indeed other banks. In other words, when the national banks (The Fed or BoE) act to shrink interest rates as in a QE scheme, the cost of capital as well is essentially reduced. The presumed consequence of a QE scheme based on several macroeconomic models, is that market players during this regime get disincentivized towards saving and gravitate towards more risky use of money to get better returns. In the wealth channel – market players who pull out of low interest investments such as bank deposits and treasuries tend to be more in search for other wealth creation opportunities. Before modern financial innovation, the traditional destination for these migrating investments would be towards fixed income securities such as government and corporate bonds and in other cases equities of companies. What is interesting to note here is that in a QE scheme such as those implemented in Japan and in the US, reducing and subsequently keeping interest rates at near zero levels are only but a first step. These National Central Banks go much further to expand their balance sheets by purchasing certain securities in an attempt to influence the traffic of investors and in general, the flow of money. The purchase of assets such as government treasuries and bonds combined with reducing the reserve requirements for banking institutions sets off a chain of reaction of both excess liquidity as well as reduced liquidity risk for investment banks and other market players – exactly the situation expected by the National Central Banks. The intended consequence usually is to unleash the massive flow of capital resulting from the combined effect of new monies in the system and the disincentive towards traditionally low risk instruments, towards riskier instruments. In terms of output, the National Banks (FED, BoE, BoJ etc.) through relatively known macroeconomic models, predict that these newly created fund flow would find their way to firms and consumers thereby helping the firms innovate and expand their business to new frontiers and the consumers borrow and spend more money at cheap rates – in short market stimulation. Financial innovations like the kind that has been experienced since the start of the 21st century has ensured that new markets beyond just stocks and equities have been created. In the last 10 years we have seen new financial instruments in active mortgage markets (in the US and the UK) such as Mortgage back securities (MBS), Collateralized Debt Obligations (CDOs), Credit default Swaps (CDSs) and Leveraged buyout in private equity (LBOs). These new instruments created alternative opportunities to invest these new funds. On the real economy, the hope was that – with the new innovations coupled with cheap capital, several key sectors of the economy like the housing markets, education, credit etc would be stimulated, jobs would be created and there would be a general boost in the economic output. At this stage we ask the question – What about the exchange rate? How does the transmission process affect the exchange rate for domestic currency? How does this affect international trade and foreign investments? To understand the effects of monetary policies on currencies, it is necessary to understand the concepts of Purchasing Power Parity (PPP) and interest rate parity (IPR). Economists generally agree that the exchange rates between two currencies relative to each other tends to correlate strongly with the domestic purchasing power of each of the currencies. This is even more the case for countries tightly integrated by commodity (especially energy) trade. Consider the basic example of crude oil as a trading commodity between two countries, say the United States and Nigeria. If we assume that crude oil trades in the US market at $US 100 per liter and in Nigeria for N15000 per liter. If we also assume that there is no cost of moving the oil from Nigeria to the US. Then depending on certain factors and most importantly the trade volume and the level of dependence of both countries on this trade, the exchange rate between the Nigerian Naira (N) and the US Dollar ($) is likely to be in the in the ratio of 15000/100 or $ 1 would exchange for N1504. Any sudden inflationary pressure on the US dollar which arguable could result from indiscrete QE applications in the long haul, automatically reduces the purchasing power of the dollar. Again, we assume a 10 percent inflation in the US for convenience and assume that 10% is transferred to the price of crude in the United States. What happens is an immediate increase in the price of crude oil in the Unites states from $US 100 to $US 110. 4 This is nearly the real exchange rate between both currencies at the moment. Now assuming that all conditions remain the same in Nigeria, the exchange rate is expected to track the new trading price of crude between both countries. Theoretically, we expect to see a ratio of 110/15000 or in other words we expect US$ 1 to exchange for N136.36, representing a loss for the US dollar of about 900 basis points. Obviously there are several other factors that affecting exchange rates. Another important factor mentioned earlier is the interest rate parity. Similar to commodity prices interest rate differences between two countries also counts as a significant factor in setting the exchange rate between currencies of both countries. Again we illustrate with the US and Nigeria. If interest rates in the US and in Nigeria are set at 1% and 5% respectively. Theoretically, investors from the US would be tempted to buy more of the Nigerian currency, or in another case banks in the US would be more interested to lend to the credit worthy Nigerian businesses. Hussman (2010) argues that this represents an arbitraging opportunity. He posits that the increased patronization of the weaker currency (in this case the Nigerian Naira), would mean that investors bid up the currency until that point is reached where it no longer represents a viable investment opportunity. If we assume this point to be a 2% increase in the Nigerian rates. It means that investors only get a difference of 2% should they decide to invest in the Naira or provide loan facilities in Naira. If we introduce transaction costs, taxes and other logistic factors involved in the movement of money, even the 2% tends to disappear and both currencies approach parity at least in regards to the value investors can derive in holding them. Based on this argument, it is easy to see how QE policies aimed at driving down interest rates in the long run actually weakens domestic currencies in relation to their foreign counterparts. 3. Discussion: impacts of quantitative easing on financial markets In the previous chapters, we highlighted a number of cases in history where quantitative monetary easing was applied to solve prevailing economic stress. It is highly important to note that in about three of the cases mentioned (Ottoman empire 1585; Great Britain 1825; Bank of England 1914), a sever hyperinflation followed. In the Ottoman Empire, inflation was said to have soared as high as 100% by 1588 (roughly three years after reducing the gold content of the coin by 44%), while Great Britain experienced it’s highest ever inflation in 1800 (36%) and in 1917 (25%) after quantitative easing schemes in 1825 and 1914 respectively. As highlighted in the transmission process – the excess monies printed or created percolate (or at least are intended to) through the relevant entities in the economy where they are then expected to spend this money on goods and services and also in acquiring assets. What happens with indiscrete QE as seen in the mentioned examples is that subsequently, there is far more money in the system than goods, services and assets. The prices of the available ones increase (inflation) and the base currency loses value. These eventually can result to loss of confidence of the public in the currency and consequently hyperinflation. Interestingly – this is not happening at the moment despite the now established inter-linkages between the US Financial Markets and the rest of the world, and after three successive massive QE applications by the US Federal Reserve Bank. The reason for this though not hidden, as many economist would argue (Auerbach, 2013), it is due to the fact that a significant portion of the US Federal Reserve’s QE funds have remained in the Reserves of Major players in the US Financial Markets, and not been in actual circulation. Having explained how unrestricted QE can cause inflation, it is important to note however that the some of the major risks that could follow excessive inflation include currency and trade wars which can be even more debilitating to the Global Financial Markets and not just the US or the other countries that employ QE Schemes. For example, countries like China and Japan with holdings of over 2. 5 trillion in US Treasuries (Katz, 2014) could suddenly see their investments loose value tremendously should there be an uncontrolled spike in inflation. This is also true for lots of other countries especially in the energy rich regions of the Gulf. Based on these arguments, it is our opinion that quantitative easing, when applied discreetly during recession, and not in cover of financial recklessness of mega corporations or governments, can indeed spur economic growth – by boosting financial markets channeling funds to the desired sectors of the economy. However, indiscrete applications have the potential to throw economies into hyperinflation and deflate severely the value of assets (including those in the financial markets). In the case of feebly integrated economies in the past (like Zimbabwe and Argentina), the sufferings of hyperinflation remained at least to a large extent in these countries. However, it remains to be seen what the effects of a hyperinflation in a well-integrated economy such as the United States of America would mean to US and the rest of the world. References Auerbach, R. (2013, June 26). Washington's Blog. 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