QE3 Consequences

?The Federal Reserve’s QE3 program’s supply of new dollars injected into the U.S. economy could carry significant unintended negative economic consequences.

The U.S. Federal Reserve’s recently announced QE3 program to buy mortgage-backed bonds might sound good to some economists, but some are already saying the plan carries unintended negative economic consequences. The Fed has promised to invest $40-billion new dollars per month until it feels that the U.S. labor market has responded sufficiently, but all those new dollars could also frighten investors, and confound central bankers everywhere but the United States, especially in emerging markets.

Some economists note that the Fed has effectively replaced the entire inter-bank money market and large segments of other markets. The Fed determines the interest rate by the rate it pays on reserve balances without considering the actual supply and demand for money. By replacing large decentralized markets with the Fed’s centralized control, many feel it is disturbing incentives and interfering with real prices.

In order to pay for the latest quantitative easing the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. The apparent limitless supply of new dollar drives the prices of risky assets higher and the policy of keeping interest rates so low for so long means that the real rate after factoring in inflation is negative, and has the effect of reducing the real income of people who have saved for retirement, as well as the assets of foreign banks at the same time.

For the central bankers abroad, the big supply of discount dollars reverses normal monetary policies. In areas where inflation is a problem, cutting the rates will reduce the value of some countries’ assets and raise funding costs. In areas with slow growth, the banks can hold rates and let the incoming money drive stocks up and corporate borrowing costs down.

After two previous rounds of artificial currency injections, investors know what happens when the Fed buys bonds with new dollars, and anything but the U.S. dollar tends to rise. In the year following QE1 in late 2008, emerging market bond yields fell, gold rose 56 per cent, oil climbed 70 per cent and Asian stocks rose 65 per cent. Similar effects followed QE2 in late 2010 until the Fed stopped buying bonds and the European Bank crisis came to a head.

Investors may turn away from commodities and emerging-market stocks and purchase higher yielding bonds from places like Australia and Indonesia. Or they might buy higher-yielding debt in less export-dependent economies like Japan and Argentina. The effects of QE3 will be felt around the world as evidenced by the fact that the Hong Kong Monetary Authority is already wondering the effects of QE3 will be on that city’s property market. Most investors will soon be looking to see if QE3 is actually working this time and if it does they may have to resort to searching for relative value instead of relative debt.