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China Review News: The Background, Characteristics and Influence of QE3
By Xiaofen Tan and Liting Deng Translator Sheng-Wei Wang
January 1, 2013

Source: http://www.chinareviewnews.com 2012-10-27 00:40:53


On September 13, 2012, the Federal Reserve (Fed) finally announced the launch of a third round of quantitative easing (QE3) monetary policy. The background of the QE3 introduction contains mainly two aspects: First, the 2012 European debt crisis continues to simmer and constitutes the biggest threat to global economic recovery. Starting from the fourth quarter of 2011, the Gross Domestic Product (GDP) for the euro area has declined for three consecutive quarters; economic growths in the emerging market countries also have slowed down. The global economy has entered a synchronized downturn and inflationary pressure has rapidly declined. While the U.S. real estate market and the job market have shown signs of stabilization, the decline of foreign consumption and the appreciation of the dollar caused by the recession in the euro area have made the U.S. economy stay weak.


Second, the risk of a "fiscal cliff" starts to show up in the US. After the end of the second round of quantitative easing (QE2) monetary policy and the Operation Twist (a monetary policy maneuver that involves the Fed selling shorter-term assets in order to buy more longer-term assets.), if the Fed withdraws its loose monetary policy, the U.S. long-term interest rates may rise. Currently the U.S. public debt reaches $16.2 trillion. If the long-term government bonds rise by one percentage point in interest rates, the event will result in an interest increase on U.S. Treasury Bonds by $160 billion. If at the end of the year it becomes necessary to reduce the deficit by force, the U.S. aggregate demand will decrease. This will further worsen the pessimistic expectations of businesses and consumers and shake the confidence of investors, which may lead the U.S. economy back into recession.


In comparison with the previous two rounds of quantitative easing monetary policy, the characteristics of QE3 mainly embody the following four aspects: First, at the same time as launching QE3, the Fed maintains the federal funds target rate unchanged in the range of 0-0.25%, and commits to keep the state of low interest rates until mid-2015, a two-year extension in comparison with QE2. In this way, the zero interest rate policy will have lasted more than 7 years from December 2008.


Second, there is no restriction on the scale and time for purchasing the mortgage-backed securities (MBS), and this can be carried out in parallel with the remaining period of the Operation Twist policies. QE2 is intended mainly for the purchase of government bonds, whereas QE3 aims mainly at purchasing the assets of the MBS. The purchase scales of QE2 and the operation twist are $600 billion and $400 billion, respectively, whereas QE3 is not preset for the total purchase scale and duration, but is with a monthly purchase target of $40 billion MBS. At the same time, the previous policy of Operation Twist (i.e., monthly purchase of $45 billion in long-term government bonds) will continue to the end of the year. Thus, before the end of 2012, the Fed's long-term monthly bond purchases will reach $85 billion.


Third, QE3 will pay more attention to the labor market, especially to the status of both the unemployment rate and the non-farm pay-roll employment. Fourth, QE3 will retain considerable flexibility. The bond purchase will be dynamically adjusted based on the change of the economic situation and labor market conditions; it will use other policy tools including balance sheet instruments and communication tools; at the same time, it will not set a definite duration. This shows that loose monetary policy is continuing; even if the economy accelerates, the loose monetary policy will not soon be tightened. Currently, the market expects the total purchase scale of QE3 to be about $600 billion and its duration to be about 15 months.


The Fed QE3 is expected to have the following effects: First, QE3 will help to curb the rise in U.S. bond yields and mortgage rates in order to ease the pressure of U.S. public debt, reducing the overall debt burden of the residents. Secondly, it will play the role of stimulating the financial markets. During the previous two rounds of quantitative easing monetary policy, the U.S. stocks showed a sharp rise and the dollar fell. It is expected that the Fed QE3 will also stimulate capital markets to rise, weaken the dollar, and push the U.S. economy toward a continued recovery.


Furthermore, after the Fed launched QE3, the world's major central banks may follow the Fed to implement loose monetary policy. The world will once again face the situation of ample liquidity, stimulating investors’ risk appetite. A lot of money will flock to gold, oil, agricultural products, minerals and other commodity markets to promote global commodity prices and cause imported inflation. However, taking into account that the changes in the commodity prices are still influenced by the demand side, in the case of the weak economic outlook, commodity prices in the short term will have difficulty rising substantially. Finally, capital flows in the international financial markets will change and capital inflows are likely to re-emerge in emerging economies. This has an active and positive impact on emerging markets that are currently facing capital outflows.


The Fed launched the QE3 policy by purchasing the MBS to aim at driving mortgage rates down and consolidating the recovery of the real estate market in order to promote resident credit and consumer recovery. At the same time QE3 can provide financial support by driving down the full range of long-term interest rates to help the government to reduce the level of debt and interest expenditures. However, in the current economic environment, QE3’s marginal effect is diminishing, the result may be limited.


On the one hand, when the QE3 was launched the federal funds rate and long-term interest rates were at historically low levels. The effect of QE3 continuing to guide interest rates downward is limited. Currently, many U.S. companies are flush with cash; the amount of deposits of commercial banks at the Fed has reached $1.5 trillion. The banking system has no lack of liquidity.


On the other hand, the U.S. unemployment is mainly caused by structural factors. QE3 is just a short-term monetary policy instrument that cannot fundamentally solve the structural problems of the U.S. economy. QE3 in the short term is conducive to avoid the downside risks of the U.S. economy, but in the long run, it could trigger a new round of global competitions of bringing high rate of return to leverages as well as long-term inflation risks.


The impacts of the first two rounds of QE policy on China's economy are mainly listed in the following aspects. First, QE made too ample dollar liquidity pour into China. The resulting renminbi (RMB) injection (by the Central Bank) has substantially increased and domestic liquidity also subsequently flooded, causing the real estate bubble and a series of problems.


Second, QE pushed up commodity prices, especially oil and precious metals prices, causing imported inflation and increased difficulty of China’s macro-control.


Third, the QE policy led to the depreciation of the dollar and hence brought great pressure to the yuan appreciation. It had a negative impact on exports. Of course, QE to some extent stabilized the U.S. consumer demand and partially offset the impact. Fourth, the QE3 policy led to the depreciation of the dollar, increasing the difficulty of preserving the value of China's foreign currency reserve assets.


Due to the differences between the global economic environment and the domestic economic cycle, the QE3 impact on China may be different from the previous two rounds. First, before the introduction of QE2 there had been an increasing influx of foreign hot money into China, the U.S. easing further exacerbated the already ample excess liquidity. Currently the yuan appreciation is expected to be substantially narrowed; in the presence of uncertainty of the real estate market and the decrease in interest rates, China is facing a net outflow of capital, which in turn leads to a liquidity tightness situation. QE3 stimulates the inflow of international capital and is conducive to improving the capital outflow pressure of China.


Second, after the launch of the two previous QEs, China's economic growth was still relatively fast, domestic investment growth was at its peak, inflationary pressures was on the upswing, and imported inflationary pressure was relatively high. By contrast, currently China’s inflation is at a lower level; the consumer price index (CPI) is still running low and the year-on-year producer price index (PPI) continues to be negative. Hence QE3’s inflationary pressure in China will be significantly less than for the previous two QEs. However, in the long term, potential risks of imported inflation are still causes for concern.


Third, the two previous QEs made the dollar weaker, which further increased the pressure of yuan appreciation. At the time when QE3 was launched, the yuan was depreciated against the U.S. dollar. Now the People's Bank of China has not injected RMB to offset the same amount of foreign exchange, but has mainly injected RMB through large-scale reverse repurchase (buying securities from primary dealers). The current deterioration of China's export situation is mainly due to the continued downturn in external demand. QE3 can help to promote the U.S. economic recovery through trade and partially offset China's exports from further sharp decline.

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Xiaofen Tan (1978 - ), male, is an Associate Professor of the Department of Finance at Central University of Finance and Economics; he is supervisor for Master degree students and assistant-supervisor for Ph.D. students. In 2012-2013 he was at Columbia University as a visiting scholar in the research areas of monetary policy and international finance. In recent years, his publications include more than 40 academic papers and a monograph. He has presided over general projects of the National Social Science Fund as well as youth projects of humanities and social sciences of the Ministry of Education. He has also participated in major research topics of the Ministry of Education, projects of the National Social Science Fund and emergency issues of the Ministry of Education.
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