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Economy Lab

QE3 may do more harm than good Add to ...

There may be a point at which global investors get indigestion from U.S. money printing.

A fresh round of U.S. monetary easing may even do more harm than good for long-term investors as another flood of easy money into fast-growing emerging economies risks refuelling oil and commodity price inflation, sapping consumption and growth.

Prospects for a third round of the Federal Reserve's quantitative easing programme (QE3) grew this month after chairman Ben Bernanke said the central bank was prepared to ease further if economic growth and inflation falter again.

Nearly in one in two fund managers surveyed by Bank of America Merrill Lynch this month said QE3 was likely.

The temptation for risk-loving investors is to rub their hands with glee. Traditionally risky or high-yielding assets such as global equities, energy and commodities and emerging markets surged in the months after the Fed gave the green light for Round Two of QE -- which involved $600-billion in new money in the form of Treasury debt purchases and which ended last month.

But the impact on the U.S. economy and the labour market has been less obvious, given that growth has slowed significantly into 2011 -- at least partly because higher energy costs have undermined consumer spending everywhere. Asset prices, as a result, have retreated sharply again since April's peaks.

This has given rise to a debate about whether QE3 works. If it doesn't give a sustained boost to financial markets and is ambiguous for the real economy, is there any point?

"We have a negative opinion of QE2, and believe QE3 could very well turn out to be ineffective at best, and counter-productive at worst," said Stephen Jen, managing partner of London-based hedge fund SLJ Partners.

"If we are right, QE will be self-defeating in that the more the Fed eases, the more commodity prices rise, which erodes the capacity of consumers to spend on non-energy products and services."

Since Bernanke unveiled the Fed's QE2 bond buying programme in a speech in Jackson Hole in August last year, Brent crude oil has risen 58 per cent, while the benchmark CRB commodities index has gained nearly 30 per cent.

Developed and emerging stock indexes are both up around 20 per cent since that speech but they are coming off their April highs. On the year both of them are largely flat.

"My best guess is that there will be a few weeks of positive reaction, followed by a selloff, as investors realise the circular and pointless logic of [the argument that] QE2 could lead to permanent increases in economic activities," Mr. Jen said.

Some advocates say quantitative easing works best by revaluing financial assets so that there will be a positive wealth effect for U.S. consumers, encouraging them to start spending again. The Fed argues that it boosts credit in a similar way to an orthodox easing by directly lowering long-term benchmark borrowing costs.

But the effect of ample dollar liquidity spreads beyond the United States, largely because emerging economies either are pegged to the dollar or have inflexible exchange rate policies. Even economies that do allow their currencies to appreciate are at risk of asset bubbles as cheap money seeks higher yields.

This means these fast-growing emerging economies effectively import the Fed's monetary easing and lift their demand for oil and commodities, whose prices also tend to rise on a weaker dollar.

The other problem is that easy money chasing high-yielding assets drives hot money into the emerging world, fans inflation and triggers monetary tightening which in turn slows growth -- creating a vicious circle.

"If QE3 is simply a repeat of QE2, I don't think it has a positive impact that has sustainability," said Bob Janjuah, head of tactical asset allocation at Nomura.

"[It] will make a commodity problem even worse. It won't help the economy but create a much bigger inflationary pressure.

QE3 will force one globally positive growth area, emerging markets, to slow down because of inflation ... We could end up with a negative effect."

Mr. Janjuah's preconditions for QE3 are a rise in the U.S. unemployment rate above 10 per cent and a 20-25 per cent fall in the S&P 500 index.

As benefits wane, many fear the cost of repeated QE operations could be self-defeating in that more money printing fuels inflation, debases the currency and ultimately raises the government's borrowing costs.

According to Mr. Jen, the Fed's balance sheet has grown by 10 points to 18 per cent of GDP in two years -- a similar scale to Japan's in the five years to 2006.

"The marginal impact of QE is decreasing progressively... The weight of debt on Fed balance sheet is increasing indeed," said Didier Saint-Georges, member of the investment committee at private asset manager Carmignac Gestion in Paris.


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