Quantitative easing
The FTSE 100, one of the major UK stock indexes, has recovered largely after the implementation of the QE. This indicated that the financial market has restored its confidence nearly back to the pre- crisis level and UK major listed companies are picking up to support the economy as well.
6,500.00
6,000.00
5,500.00
5,000.00
FTSE 100
4,500.00
4,000.00
3,500.00
3,000.00
02-Jan-09
02-Jan-10
02-Jan-11
02-Jan-12
Fig. 6 FTSE 100 historical prices Source: Google Finance
QE can be a two-edged sword. A direct downside is inflation. The inflation target is normally set at low CPI rate in many developed countries, for example both 2% in Britain and US. When large quantities of financial assets are purchased, the new money then flows into commodities, construction, and housing market and other forms of consumption and investment. This will push up the general price level, lead to both cost-push and demand-pull inflation, and then may exceed the target. As an inflation target is often the primary objective of a monetary policy committee, the size of QE has to be taken into account. However, a sustainable inflation rate would stimulate spending as people would worry about the decline in purchasing power of the currency in the future. Borrowers would also benefit from the decrease of the real interest rate. Another drawback is the depreciation of the currency. Once the monetary base is expanded hugely, the supply of the currency increases which will cause the exchange rate to drop. This will be a disaster for countries like Britain which runs a large trade deficit; but this can be an advantage for export-oriented economies because it makes exports cheaper in terms of another currency. Lastly, the size of QE is difficult to balance effectiveness and inflation target. From my point of view, QE works well as an ancillary policy to ZIRP, and a favourable strategy to pull our economy out of crisis. Other than the direct effect on the price and yield of asset that the central bank purchases, there are many channels through which QE could improve the situation. Confidence could be restored, lending could be increased, employment could be created, and financial markets could be revived. Imagine the whole economy works like a circulation system in our body, with money and credit as the blood flowing around. When the crisis comes – usually after a boom period – it acts like excessive cholesterol accumulated after gluttony which clogs the blood vessels. QE brings in the new money just like a kind of drug, which can remove the blockages and then allow the blood to flow smoothly again in our body.
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