To QE, or not to QE? A response with low interest.

How effective was the U.S. 'Fed Bazooka' in response to coronavirus? With reference to work by Mohamed El-Erian.

There are a variety of fiscal policies and stimulation packages going around at the moment in response to the global coronavirus economic and health crisis. Last week, the US Federal Reserve decided to slash interest rates in order to – essentially – make paying back debts easier. If interest rates are lower, then loan repayments are less expensive. Why did the Fed do this? Because less expensive debt servicing frees up income to tide businesses (and individuals) over until quarantine ends and, hopefully, the economy is stimulated again by spending.

So, whats the point in making debt less expensive?

The reason that small businesses need extra cash is because we are currently experiencing ‘supply and demand shock’. This is where there are issues both in consumer demand (e.g. purchasing goods and services) and in the supply chain (obtaining the materials that make up those goods and services). This is because manufacturing (mostly in China) and consumer spending have slowed significantly due to the virus.

The issue with this low interest rate initiative is that although low interest rates encourage spending, Covid-19 limits not just access to cash but also actual ability to spend: this is because bars, restaurants and most shops remain closed and most flights and tourism stay grounded. The Fed tried to use extremely low interest rates to calm the markets and stimulate spending, but global crashes suggest it has not had this effect. So, why is this? Low interest rates (and QE) have, rather than stimulating the economy, spread panic through it. The ‘radical’ measures, argues David Madden of CMC Markets, have sent out a worrying message to dealers, causing them to blindly dump stocks. Mohamed El-Erian sums it up: ‘when people cannot sell what they want to sell, they sell whatever they can sell’. In fact, spending has not been stimulated because it cannot be stimulated, really, while the virus continues to cause this supply and demand shock.

Let’s take a closer look at this with El-Erian’s opinion on the ‘Fed bazooka’ in his Bloomberg piece last week. He described the move as ‘premature for economic well-being [and] for maintaining financial stability and perhaps for safeguarding the future effectiveness of modern central banking’. He is describing not only the slashing of interest rates to near zero but also the $700 bn asset repurchase program and initiation of QE.

Hold on, what’s QE?

Quantitative Easing (QE) is an ‘unconventional’ monetary policy used to stimulate an economy when ‘conventional’ money policy becomes ineffective. A central bank will buy financial assets (typically debt in the form of Treasury bills, notes or bonds and mortgage-backed security or MBS paper) from commercial banks and other institutions. This purchase creates money because it injects a pre-determined quantity of money into the economy. Normally (not with QE), the central bank would purchase bonds to lower interest rates and increase the amount of money in the system. With QE, interest rates are already 0, and the Fed cannot alter the price of money. All it can do is alter the quantity of money, and the name of the process when only the quantity is altered is quantitative easing. Thanks to Chris Martenson of www.peakprosperity.com for this explanation.

Back to El-Erian.

Let’s briefly summarise El-Erian’s five key concerns on the U.S. QE response to coronavirus. Firstly, economic activity is slowing because there is halted consumer spending caused by limited travel and economic interactions. The Fed responded by making loans cheaper and putting cash in pockets from lower mortgage payments. This doesn’t help the issue of getting people out of self-isolation and out spending. Secondly, the injection would help high-quality bonds and encourage credit extension to limit risk of liquidity issues becoming solvency issues – but this has a much less direct impact on other segments of finance, including corporate bond value. El-Erian calls for more targeted measures. Thirdly, a near zero interest rate exhausts the interest-rate mechanism at a time when the markets remain incredibly volatile and uncertain and leaves policy an economic mechanism ‘strained’. Also, as the solvency crisis is a risk globally, the markets in Europe are actually issuing counterproductive economic and financial outcomes, and these continue to encourage volatility – this is despite of and unhelpful for US measures. Fourth, deep-pocket buyer investment in the stock market will stimulate growth, but the potentially premature Fed bazooka may inadvertently keep this essential investment hesitant to engage. El-Erian suggests that the measures even provide a ‘bigger door’ for trapped longs and other distressed sellers to exit. El-Erian emphasises that measures need to be packed with reassurance in order to stimulate investment. QE it seems has had the opposite effect.

The laser-focus

Today, Seeking Alpha reported on the Fed’s ‘whatever it takes’ attitude. The Fed is now buying corporate bonds, but this is not unlimited. The government cannot purchase more than 20% of any one ETF, or 10% of individual corporate bonds. Further, purchases will only be made in investment grade corporate bonds, not high yield bonds. This means that the most vulnerable companies (who issue high yield bonds because they are high risk) might be left to service their debt without laser-focus assistance. To ease the high yield issue – which is exacerbating by social distancing & limited consumer transacting a.k.a. ‘demand shock’ – the White House is discussing easing social distancing guidelines ‘as early as next week’ according to Seeking Alpha. Trump’s sentiment: ‘We’re not going to let the cure be worse than the problem’. A response seemingly in line with El-Erian’s sentiments, but we have yet to see if this is feasible before we even consider its being successful.

Now that the US has taken on some laser-focus, this will be further explored n another post. This post served to explain the QE measures in the US and their implications. I hope it helped. Until next time, let’s hope panic subsides.