The world has been through massive crises that have put a lot of households and businesses into the gutter. Even a supergiant like the US has had its fair share of shocks and meltdowns that disrupted macroeconomic growth and depleted the wealth of many Americans.
The Great Depression, the dot-com bubble, and the real estate bubble were notorious examples. Many Americans were still stuck in the financial quicksand even a decade after the Global Financial Crisis.
In 2020, the US experienced another recession as the pandemic led to mass business shutdowns and layoffs.
Amid all these, policymakers tried to alleviate the dire scenario. The Fed employed quantitative easing for the first time since the Great Recession. It proved effective as business recovery took place despite supply chain challenges. The US economy regained footing in 2021 as restrictions eased, allowing multiple business reopenings. Sadly, it did not last long as inflation sped up, exacerbated by weak external factors.
Today, we can see the continued inflation deceleration after a series of interest rate hikes. The Fed already paused hikes for three consecutive meetings, erasing fears of another recession.
In fact, they’re eyeing a rate cut in the second half of this fiscal year. With the current macroeconomic condition, one may wonder whether implementing quantitative easing can bolster recovery and growth. This article will cover the US economy and assess the potential implications of quantitative easing.
An Overview of the US Macroeconomic Condition
The US economy has been highly volatile in the past two years. After near-zero interest rates drove spending and borrowing splurges, supply could no longer keep up with demand.
This was aggravated by the Russo-Ukrainian War, which affected supply chains and oil prices. In turn, inflation accelerated and reached its highest point of 9.1% after many years. To that end, the Fed implemented a series of interest rate hikes, exceeding 5% for the first time in many years.
These sudden economic shifts discouraged borrowers and investors for a specific time. It also affected the value of the US Dollar (USD), lowering capital inflows.
Most importantly, it led to the softening of aggregate demand, slowing down economic activities.
Consequently, recession woes once again seeped through every household and business. So, policymakers had to be more vigilant to stabilize the economy.
Thankfully, tightening the money supply proved effective as it slowed down inflation in the following months. At the end of 2022, inflation dropped by 29%.
Inflation deceleration persisted in the first quarter of 2023, landing at 5%, a 45% reduction from the 2022 peak. As such, the Fed was able to pause rate hikes to help borrowers, lenders, and investors.
All these actions turned out well as inflation decreased and approached the Fed’s target range of 2-3%. Some upticks exceeded analysts’ consensus, especially in the third quarter of 2023, but remained manageable.
At 3.4%, inflation is now 60% lower than in 2022. Even better, interest rates remain untouched, helping the financial sector bolster its rebound. This allows the USD to keep its value high relative to other primary currencies.
Quantitative Easing: What is it?
Quantitative easing, or QE, has always been used a lot of times by many central banks across the world during recessions. It has helped boost economic activities and encourage capital inflows to speed up macroeconomic recovery.
Quantitative easing is a central bank tool or monetary policy employed by the central bank to reduce interest rates and raise the money supply. The goal is similar to an expansionary monetary policy, wherein the central bank lowers interest rates.
But in QE, central banks like the Fed make large-scale purchases of financial instruments like debt securities instead of directly adjusting interest rates. These can be government bonds, corporate bonds, and stocks. This move has proven to trigger powerful outcomes. The Great Recession and the pandemic recession were some instances when the Fed applied QE.
Another difference between the QE and an expansionary policy is their specific targets. The former helps lower longer-term interest rates by buying securities with longer maturities. Meanwhile, the latter lowers short-term interest rates by working on interest rate policies alone.
As such, QE helps lower longer-term interest rates in borrowings, which can stimulate private consumption to spur economic growth.
The most crucial distinction between the two is the right timing for their use. Lowering interest rates to encourage lending is often not applicable during periods of high inflation. This will exacerbate stagflation and can lead to a recession. That is why the Fed did not cut the interest rate to zero or near zero during the Global Financial Crisis.
Instead, QE was applied by purchasing treasury bonds and mortgage-backed securities (MBS) to increase economic liquidity. Lowering interest rates can be risky during hyperactive or volatile macroeconomic conditions. QE is safer since the Fed will not directly influence consumption and borrowings.
Potential Impact of Quantitative Easing
At this point, we already know the direct impact of QE on the economy. But it is more important to determine how and how much it will affect the US economy should the Fed deploys it.
As inflation decelerates, many individuals expect the Fed to cut rates this year. That is why quantitative easing is one of the tools to stabilize macroeconomic indicators.
Risks of quantitative easing
While QE appeared helpful for many economies, central banks must remember that this tool may only apply to some economies. These are the risks associated with quantitative easing.
Inflation rebound and wealth inequality
One of the biggest dangers of injecting more liquidity into the US economy is the inflation uptick. The most recent report of 3.4% is higher than the previous month’s 3.1%. Even so, we can attribute it to holiday spending splurges.
Right now, the Fed has yet to hit its 2% inflation target before it can say the economy is already stable.
Inflation is still elevated despite the massive reduction from 2022 levels. If the central bank deploys QE, the higher aggregate demand can lead to shortages. While it can be good to drive economic activities, it can also put upward pressure on prices. Even worse, inflation may make another uptick.
The consolation is that inflation does not always take place. Take the Fed’s QE in 2019-2015 to lessen the impact of the Global Financial Crisis. But QE often applies during a recession, and the US isn’t experiencing it now. Implementing QE can lead to it.
The thing is, QE-driven inflation can lead to instability in general price levels since it may affect mostly goods with the highest demand. Some goods will not feel its impact and can even have lower prices. These include inferior goods, such as canned goods and instant noodles. This opposing trend is often called the Cantillon effect or biflation.
Lastly, QE-driven inflation can cause income inequality. It will be more evident in the financial and real estate markets. Note that assets like real estate do well when prices go up.
Dollar depreciation
Quantitative easing may also devalue the US Dollar (USD) due to a lower interest rate and higher inflation. Currency depreciation can help domestic manufacturers make exports cheaper in the global market to capture more foreign demand.
However, it can make imports more expensive. It will be challenging to import raw materials, so production costs may increase. In turn, prices may increase more, leading to higher inflation.
Positive impact
QE can be a crucial tool as the US economy is still on its way to recovery. QE can further bolster economic activities even after the holiday spending splurge. These are the advantages of QE.
More robust economic activities
With lower interest rates driven by quantitative easing, there will be higher confidence about economic stability. Lower interest rates can entice businesses and households to borrow money and invest in financial markets, which raises the money circulating in the economy. As such, the financial system becomes more liquid.
If we combine all these, there will be higher consumption, prompting businesses to increase their production capacity. In turn, they must increase their production inputs, particularly labor. This will increase the employment rate in the US. And again, higher employment means higher purchasing power, which raises the aggregate demand and income.
Effective asset allocation
Bond prices will increase if the Fed makes large-scale purchases of T-bonds and other fixed-income securities. Yet, yields will decrease, making bondholders’ earnings lower than before the QE deployment. On a lighter note, lower interest rates lower borrowing costs, allowing them to increase their spending and investment in other markets.
That is why QE can bolster the US stock market performance. Investors will turn to higher-return assets like stocks, forex, and cryptocurrencies. As a result, their value may appreciate, leading to sustained gains.
With lower interest rates, prudent risk-reward management will be easier. Annual returns will limit the impact of the risk-free rate or the 10-year treasury yield. Note that in the Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha, treasury yields are deducted from annual return to derive the risk premium.
Takeaways
The US is on its way to complete recovery, characterized by manageable inflation and interest rate hike pauses. Policymakers may think about applying QE to achieve complete recovery in no time.
However, QE may only sometimes help in some scenarios and may compromise the effectiveness of other monetary policies. The Fed may think twice before using it to stabilize inflation and interest rates.
