The US Federal Reserve seems to have finally committed to another round of quantitative easing (QE), the third of its kind since 2008. The minutes of the Fed’s apex Open Market Committee meeting – held at the end of July – released on August 22 suggested that a majority of its members favour another round of hefty liquidity infusion to fight the enduring slowdown in the US economy. To quote the minutes: “Many [voting Federal Open Market Committee] members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”
The minutes also seem quite clear that the committee favours large-scale asset purchases, possibly a combination of mortgage securities and treasuries. Even as the majority of market analysts had been expecting QE3 sometime over the next six months, this commitment seems to have come their way sooner than expected.
The immediate response to the minutes was on expected lines. The dollar sold off, risky assets rallied and the euro and emerging-market currencies appreciated. However, the first round of euphoria lasted for just about a day and then fizzled out. Why? For one thing, while the minutes seem to suggest that QE3 is probably a done deal, there is considerable uncertainty about the timing. Unlike QE2 in 2010, when markets rallied in anticipation a good couple of months before the actual announcement of the programme, markets seem a little more circumspect this time and perhaps want to see the contours of the policy before getting too carried away. Even as diehard optimists expect the Fed to announce the policy mid-September, the majority market view seems to be that the American central bank will hold off until November or December around the time that anxieties over the fiscal cliff surface.
The other factor that reined in the euphoria was the resurgence of concerns about Europe, particularly Greece. Just a day after the minutes were announced, German Chancellor Angela Merkel and French President Francois Hollande emphasised that the European Union (EU) was unlikely to offer Greece much leeway in getting its fiscal act together. Thus, the risk of yet another default by Greece on its sovereign obligations and ultimately an exit from the currency union itself seems back on the table.
There is a perhaps a broader lesson in this. Given the fiscal problems of both the US and Europe, liquidity alone might not give the markets much of a pop if fiscal risks intensify. If Grexit seems a reality or if there is a partisan face-off over a resolution to the fiscal cliff, the markets are unlikely to press their “risk-on” switches even if central banks pump in gallons of liquidity. Thus, quantitative easing, the strategy of throwing money at a problem, whatever its shape or hue, could be losing its edge. Markets want to see specific solutions for specific problems — not just hear the sledgehammer thump of money printing machines.
This brings us to the somewhat curious case of the euro that despite the myriad woes of the currency union has held up quite admirably. Those who predict QE in the US also predict a large-scale bond buying programme and other forms of liquidity easing by the European Central Bank (ECB) before the year is out. The question is: what will happen to the euro-dollar exchange rate when both zones do their own versions of QE. If last year’s Long Term Refinance Operation of ECB is something to go by, the Europeans can be more aggressive in cranking up their money machines. In short, more euros could be pumped into the markets at the year-end than dollars. The consequence, following Econ 101 and fourth standard arithmetic, should be a depreciation in the euro.
However, the euro’s resilience and indeed its gains against the greenback could just be telling us that this need not be the outcome. There seems to be a belief in the markets that the Europeans are quietly working towards a solution to their fiscal problems and the stress on the banking sector that resulted from this. Thus, the region’s policy-makers could just be taking longer steps towards the creation of a workable fiscal union or more likely a banking union. An operational fiscal union would, in effect, centralise the tax-and-spend policies of member economies in the EU and ensure better fiscal discipline across the region. In return, the better-off core economies (Germany) could perhaps provide some short-term succour (through transfers perhaps) to ailing peripheral economy. It would also facilitate common bond issue for the region. In this, Germany and other solvent nations’ creditworthiness will compensate for the low credit rating of the periphery.
A banking union would involve, among other things, a central recapitalisation facility that can provide capital to stressed banks and a central deposit insurance facility. Clearly neither a fiscal nor a banking union is the easiest things to put in place. The political and bureaucratic tangles alone could take months, if not years to sort out. However, markets have a niggling hope that Brussels’ boffins could pull something off by the year-end. Were that to happen, the sentiment towards the euro could reverse and completely overwhelm the pure liquidity effect. A sharp rally in the euro cannot be ruled out, especially since for the past few months it has been hugely “oversold”. For forecasters like me who have a somewhat bearish call on the euro, that’s a risk we cannot afford to ignore.
The author is with HDFC Bank. These views are personal
