Quantitative Easing and the G7

Dean’s headline this morning noted that quantitative easing was something we would all be getting to know very well in the near future. Because many of the G7 countries have dramatically reduced interest rates , the central banks are now in a zero-bound situation and are unable to make further cuts. We talked about the implications of a near-zero interest rate policy in an earlier commentary but with yesterday’s interest rate cut by the Federal Reserve, it deserves revisiting.

We typically think of interest rate cuts as the standard response when the goal is to increase spending in a shrinking economy, but this has already been tried with only limited success so far. At 0.25% and 0.3% respectively, the U.S. and Japan are basically at zero percent now and Switzerland is not far behind at 0.5 %. Further rate cuts are also expected soon in Canada and England which should bring both countries into the 1% range.

So with interest rate cuts off the table as a means to kick-start the economy, the time has come to turn to the quantitative easing play book. Quantitative easing is specifically intended to increase spending which is exactly what is needed during this time of tight credit and a growing reluctance of consumers to part with their cash. This reluctance is understandable in the face of uncertainly in the markets and frightening prospects on the job front, but we risk a serious case of deflation if consumers cannot be convinced to spend.

Quantitative easing works by making more money available to the commercial banks and other lending institutions thereby increasing the liquidity within the system. Interest rates cannot fall any further, but the central banks can continue to shovel money into the economy and with all this cheap money floating around, someone is bound to spend it, right?

Well, that’s the theory at least, but I would argue that the U.S. in particular has been following a policy of quantitative easing for a year now starting when the Fed introduced the Term Auction Facility (TAF) last December. TAF was designed to provide more funds into the American banking system and the more recent moves by the Treasury to fund the financial sector to the tune of $700 billion and even the impending automakers bail-out are all elements of quantitative easing.