Can Quantitative Easing be phased out without causing turmoil in the U.S. and abroad?

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Alwin Adityo's picture

 

In the midst of the global financial crisis, the Fed implemented a policy called quantitative easing (QE) to increase money supply in order to stabilize the economy. Started in 2008, this unconventional monetary policy has resulted in the expansion of the Fed’s balance sheet from $ 870 Billion to $3.8 trillion in 2013[i]. The tapering of QE in the U.S. is an issue particularly of concern not just to the U.S. but also to the U.S.’s trading partners in Asia such as Indonesia and Hong Kong. The tapering of QE could cause excessive fluctuations that destabilize the financial market and macroeconomic conditions in those countries. Moreover, due to the importance of China’s role in the global economy and trade, the decision to taper of QE to China should be considered. 

The Fed needs to find ways to phase out QE without causing harmful effects to the domestic financial market and economy. If the Fed takes the wrong steps, potential threats include high interest rates and a stronger U.S. Dollar. According to Mike Patton from Forbes, higher interest rates can have two detrimental effects, which are higher mortgage rates and higher costs to the federal budget[ii]. Higher mortgage rates could slow down the present recovery of the housing market, as people will be reluctant to take out home mortgages. On the other hand, higher costs in the federal budget as a result of the increase of one percentage point of the interest rate could cause budget savings created from the previous sequester to be erased.  An excessive selling of the Fed’s excess reserves can cause Banks to face a shortage of funds to lend out, thus the demand for U.S. dollars outstrips the supply that lead to an appreciation its value, thus U.S. exports would lose competitiveness due to the strong dollar. Furthermore, the news of the tapering of QE could initially cause volatility in the financial markets, as investors initially are frightened and uncomfortable to the idea of a reduction in QE. However, the phasing out of QE in the U.S. is necessary, as it was found out to have a minimal impact on the economy after its introduction. Research by Bill Conerly from Forbes showed that QE was not primarily responsible as the driving force of the economy[iii]. Conerly argued that despite a growth in GDP that happened a few quarters (time lags of monetary policy are long) after the first round of quantitative easing (QE1) happened, such growth is normal for an economy that is coming off a recession. Regarding the money supply, QE1 and the second round, QE2 increased the money supply growth dramatically. However, money supply growth rates declined in QE3, which according to Conerly indicates that the stronger bank reserves have been simply held by banks and not lent out to buyers and consumers. Hence, the tapering of QE in the U.S. should be gradually, as many sectors could be affected in a negative way if it was pulled out immediately. 

            If the present state of the economies of the U.S.’s trading partners exists while QE is phased out, phasing out QE will hurt. Hong Kong is reliant on the U.S. for its monetary policies as it pegs its currency to the U.S. Dollar, therefore it has to import the U.S.’s monetary policy in order to maintain the peg. Hong Kong’s Monetary Authority thus also had to use QE that has led to an unprecedented boom in its housing market, where property prices have risen by 128 percent since 2008[iv]. If QE is tightened, it will also tighten liquidity and raise interest rates. According to Nomura, this situation could escalate into a gruesome situation similar to the 1997 crisis where the property bubble burst led to a sharp decline in consumption, derailing the economy into a deep recession[v]. Hence, as long as Hong Kong continues to peg its dollar to the U.S. Dollar, a phasing out of QE by the Fed could potentially cause financial and economic instability.

            Developing economies with current account deficits such as Indonesia are expected to also to suffer from the tapering of QE. Indonesia was the subject of foreign capital inflows during the peak of QE in the form of portfolio investments that appreciated its currency, the Rupiah, during the global financial crisis. Phasing out QE by the Fed would mean capital outflows of their stock markets and a depreciation of the Rupiah. The Rupiah, was the worst performing currency in Asia in 2013 with its value against the U.S. Dollar declining by 26.2 percent[vi]. However, like Hong Kong’s case, the phasing out of QE should not be blamed solely for the deteriorating conditions. The presence of large current account deficits increases the reliance on capital inflows from portfolio investments for financing, which in a couple of years earlier came from money resulting from QE. Hence, QE can be reduced without creating a negative impact on Indonesia if internal measures by Indonesia to reduce the current account deficit are improved, such as reducing reliance on imported subsidized fuels. As 2014 is an election year, a policy geared toward reducing the current subsidy seems unlikely. Therefore, technically phasing out QE by the Fed will result in more instability for Indonesia. However, Mirza Adityaswara, the Deputy Governor of Bank Indonesia stated Indonesia was severely bullied by global investors due to a threat in the phasing out of QE by the Fed and resulted in the undervalue of its bonds and currency[vii]. Hence, if the Rupiah could rally to become one of the best performing currencies in Asia this year, a phasing out of QE by the Fed would have minimal impact on the economic conditions of Indonesia.

The impact of tapering QE to China should be considered. China in 2012 eclipsed the U.S. as the world’s most prominent trading partner and it overtook the U.S. to become the world’s largest trading country in goods in 2013[viii]. Hence, China is a vital trading partner for most if not all countries in the world and the effect that China receives from the tapering of QE could have a domino effect on the global economy. Experts thus far have been split on their opinion on how the tapering of QE could impact China. In 2012, due to the heightening of the European sovereign debt crisis, China’s capital outflows totaled $100 Billion or equivalent to 1.2 percent of their GDP[ix]. If the Fed decides on tapering, a large-scale capital outflow that can squeeze liquidity conditions in China can happen, states Rob Subbaraman, the chief Asia economist at Nomura[x]. As a result, China’s economic growth will be slowed and causes a negative impact for the economies of countries that rely on China for exports due to lower demand from China. On the other hand, the tapering of QE could also benefit China if the tapering of QE is a true indicator that the U.S. economy is improving, according to Louis Kuijs, the chief China economist of RBS.[xi] An improved U.S. economy will benefit China, as the demand for Chinese goods in the U.S. will increase. To prevent the effects of the tapering of QE negatively affecting China, officials from both countries should cooperate together in areas such as increasing the transparency of monetary policy and strengthening financial supervision.

            Therefore, it can be concluded that the Fed should carefully evaluate all possible outcomes for both the domestic and foreign economy that could happen as a result of the tapering of QE. The tapering of QE, although necessary, could cause problems for the U.S. if done too aggressively. Furthermore, due to current economic conditions and policies in countries such as Hong Kong and Indonesia, their economic and financial markets might not be ready to initially adapt to a sudden stop in QE. Hence, a timetable to pull QE should be transparent and be conducted gradually. Moreover, the Fed should look at QE’s impact on China, as the growth of many economies has positive correlation with the financial and economic conditions of China. 

 

[i]  Fabbri, B. (2013). QE Tapering and Its Impact on Asia . National University of Singapore. Singapore: National University of Singapore.

 

[ii] Patton, M. (2013, September 19). The Effect Of Fed Tapering On The Economy, The Housing Market And Stocks . Retrieved February 2, 2014, from Forbes: http://www.forbes.com/sites/mikepatton/2013/09/19/the-effect-of-fed-tape...

 

[iii] Conerly, B. (2013, December 18). Fed's Taper Will Have Negligible Impact On Economy . Retrieved February 3, 2014, from Forbes: http://www.forbes.com/sites/billconerly/2013/12/18/fed-taper-not-changin...

 

[iv] Harjani, A. (2013, May 28). Here’s How QE Tapering Could Hurt Asia. Retrieved February 2, 2014, from CNBC: http://www.cnbc.com/id/100768734

 

[v] (Harjani, 2013)

[vi] Sambijantoro, S. (2014, January 17). Rupiah to become Asia’s Best. Retrieved February 2, 2014, from The Jakarta Post: http://www.thejakartapost.com/news/2014/01/17/rupiah-become-asia-s-best....

 

[vii] (Sambijantoro, 2014)

[viii] Keating, J. (2014, January 13). China Claims Title of World's Top Trading Nation . Retrieved February 5, 2014, from Slate: http://www.slate.com/blogs/the_world_/2014/01/13/china_claims_title_of_w...

 

[ix] Naidu-Ghelani, R. (2013, June 7). Fed Tapering Could Mean Instant Problems for China . Retrieved February 5, 2014, from CNBC: http://www.cnbc.com/id/100797503

 

[x] (Naidu-Ghelani, 2013)

[xi] (Naidu-Ghelani, 2013)

References: 

Fabbri, B. (2013). QE Tapering and Its Impact on Asia . National University of Singapore. Singapore: National University of Singapore.
Harjani, A. (2013, May 28). Here’s How QE Tapering Could Hurt Asia. Retrieved February 2, 2014, from CNBC: http://www.cnbc.com/id/100768734
Patton, M. (2013, September 19). The Effect Of Fed Tapering On The Economy, The Housing Market And Stocks . Retrieved February 2, 2014, from Forbes: http://www.forbes.com/sites/mikepatton/2013/09/19/the-effect-of-fed-tape...
Sambijantoro, S. (2014, January 17). Rupiah to become Asia’s Best. Retrieved February 2, 2014, from The Jakarta Post: http://www.thejakartapost.com/news/2014/01/17/rupiah-become-asia-s-best....
Conerly, B. (2013, December 18). Fed's Taper Will Have Negligible Impact On Economy . Retrieved February 3, 2014, from Forbes: http://www.forbes.com/sites/billconerly/2013/12/18/fed-taper-not-changin...
Keating, J. (2014, January 13). China Claims Title of World's Top Trading Nation . Retrieved February 5, 2014, from Slate: http://www.slate.com/blogs/the_world_/2014/01/13/china_claims_title_of_w...
Naidu-Ghelani, R. (2013, June 7). Fed Tapering Could Mean Instant Problems for China . Retrieved February 5, 2014, from CNBC: http://www.cnbc.com/id/100797503