Monday, June 13, 2011

What happens when QE2 ends?

The Financial Times uses a combination of theoretical and empirical arguments to predict (suggest?) that the end of the so called QE2, the increase of supply of long term debt by the Federal Reserve, will result in a decline in asset prices.  One theoretical mechanism that would predict such an effect is that the end of low US interest rates will lead to a stronger dollar which will discourage exports:

The flood of dollar liquidity that has been poured into the market by the Federal Reserve has encouraged the growth of the so-called carry trade, in which currency investors sell the low-yielding US currency to invest in alternatives with higher interest rates such as the Australian dollar.

Many Asian reserve managers feel that the Fed’s quantitative easing policy was a deliberate attempt to engineer the dollar lower, to the benefit of the US economy. Thus, the end of QE2 may prompt a reduction in their diversification away from the dollar.

The empirical story is illustrated by the picture below, and the following discussion:
“Asset price inflation really is a consequence of QE,” says Paul Marson of Lombard Odier, a Swiss private bank. A 90 per cent rebound in the S&P 500, the main US share index, since its low point in March 2009 has coincided with the Fed’s two QE programmes. Commodity prices, as shown by the Reuters Jefferies CRB index, are up 67 per cent over the same period, while the dollar has fallen 17 per cent.

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