Quantitative easing: the hot money problem

DESPITE murmurings to the contrary by various members of the Federal Open Market Committee (FOMC), it seems that the US Federal Reserve’s $600bn (£368bn) scheme to purchase Treasury bonds will run its full course, up to June as initially planned. But an intervention the size of QE2 cannot just come to a sudden halt and the Fed go Treasury cold turkey. As a result, the after-effects should still keep the dollar low for a while longer

Buts the interventionist measure tails off, there are worries about the fortunes of US bond yields. These fears will have been exacerbated by Pacific Investment Management (Pimco), the world’s largest bond investor, shorting US debt to the tune of $7bn.

Beyond the danger posed by a lack of confidence in the ability of the US to address its enormous budget deficit, the end of QE2 will affect not just US domestic affairs, but the global currency markets. Anybody investing in the forex market should be keeping a close eye on these developments.

Should the artificially low US interest rates continue – the overnight rate currently is held around zero – it will continue to result in detrimental knock on effects around the developing world. The policy makers of emerging markets are worried that hot money will keep flowing from the low interest rate yielding dollar into higher interest rate currencies of emerging markets as investors attempt to ensure they get the highest short-term interest rates possible. If the volume of these transfers is high enough, it has an impact on exchange rates and so on the trade balance.

Last year, China’s vice finance minister Zhu Guangyao voiced his objection to QE2, and its hot money effects, saying “the major problem is the different situation compared with the period of the financial crisis. Now the capital market has money, but it doesn’t have confidence in supporting the economy. International capital wants profit. So a big portion of that $600bn will flow into emerging markets, and place pressure on the capital market. It aims at gaining short-term profit, so it will leave very fast.”

However, Steen Jakobsen, chief economist of Saxo Bank, thinks that sights should be shifted away from the announcements of the FOMC and ECB and says that we should instead be focusing on those countries that are actually capable of exporting capital: “Chinese lending rates have led inflation, and as a second derivative the inflation expectations – those very same inflation expectations that are now getting every single central bank to talk hawkish. China is ratcheting bank reserve requirements higher and hiking rates to curtail the inflation impact on their economy, well ahead of the curve along which the ECB is now also moving and the Fed is lagging far behind. At the same time, however, we have the world’s other key net exporter of capital, Japan, in an entirely different situation than China. In response to the terrible aftermath of the 11 March earthquake/tsunami, Japan is providing a massive new global stimulus and effectively a new QE3.”

Kully Samra, UK branch director of Charles Schwab is buoyant about the post-QE2 outlook for the American economy, taking the view that the economy has enough slack to take the money flows once the money-printing ends. “It is heartening that we are not having serious discussions about QE3, QE4 et cetera in the US. Although the Fed has flooded the system with cheap currency, the velocity of money remains depressed and the core inflation rate has been benign (see graphs above). With PPI up and the money multiplier still low, we should avoid another round of quantitative easing in the US for the near future.”

Whether we see further rounds of quantitative easing, America’s attitude to the international protests against their monetary policy is somewhat of an echo of that taken by John Connally, Jr, Richard Nixon’s Treasury secretary. Defending the 1971 $40 bn budget deficit as an essential “fiscal stimulus” he remarked to a European delegation worried about exchange rate fluctuations that the American dollar “is our currency, but your problem.” Nixon’s government stepped in to try and control inflation following this raising of the debt ceiling. The measures backfired. Hopefully this time it will be different.