Quantitative Easing (QE) describes a situation when a central bank uses newly created money to buy assets in national stock exchanges. The bank mainly buys government bonds in the secondary market, with the goal of directing the money into the economic system. This money is intended to flow through the system, create economic activity and stimulate inflation. This article will show how QE affected the economic systems of the US, Eurozone and Japan.
The most important central banks that executed QE measures were the Fed, the ECB and the Bank of Japan (BOJ). The following timetable summarizes the banks’ executed QE programs:
In total, between December 2007 and June 2015, these central banks purchased securities worth billions in their national currencies:
This means that the major central banks, their governments’ bankers, are now holding the most assets they have ever held:
It is visible that the Fed’s assets have grown by almost eight-fold in fifteen years, with the ECB and BOJ’s assets growing about four-fold in the same period. The ECB and BOJ will see further growth in their assets in the coming years as they continue their QE schemes, while the Fed has stopped its mass purchasing of securities in October 2014.
The effects of QE
These central banks have been influencing the markets quite strongly through QE. By injecting money into the system quick and fast, the operation worked and saved the markets from the consequences of a second great depression. Nevertheless, QE had several side effects that brought change to the economy:
First, as the central bank acquires securities in secondary markets, it brings to an increased demand for financial securities and applies a force for higher prices. As QE is executed together with near-zero base interest rates, the stock markets see large inflows of capital due to both actions. These two actions intensify each other, fueling lengthy increases in the price of all securities on average.
These high prices should encourage IPOs and debt raising through the public markets and encourage investment in capital goods in the economy. However, capital flows into the stock markets as a result of QE combined with low interest rates reinforce each other, feeding immense optimism that drives valuations far from reasonable value. As this process continues, the system is destabilized due to the greater gap between dream and reality.
The following chart shows the change in the main stock market indexes from December 1999 (major recessions emphasized by yellow circles):
It is visible that while the four stock markets mentioned above have reached their December 1999 price level in 2007, it took them some time to reach those levels again, with the Nikkei reaching it only in 2015. It is interesting to note that while the US and Eurozone GDPs have grown by 20% and 7% respectively since December 2007, the Japanese GDP is actually 2% lower than it was back then, when measured in current prices. This is a weakness point for the sharp rise in the Nikkei since 4Q 2012.
Second, from the savers and speculators’ perspective: as prices rise in all asset classes on average, their yields drop. This fact pushes investors to seek riskier assets in order to achieve their return goals, bringing to an increase in the overall risk-reward ratio in the market. This reduces investors’ expected wealth as they are forced to seek riskier assets in order to earn a decent return. As prices continue to rise, this process intensifies.
Third, on the good side, QE allows new money to enter the economic system and is expected to create new demand for goods and services, as people feel wealthier. That demand tackles opposing forces of deflation caused by uncertainty among consumers, and overcapacity in China which forces producers there to lower prices, sometimes to levels of dumping.
The following chart summarizes the change in CPI in the major economies from 31 December 2007:
Inflation was in fact slowed. We can see this when we compare the periods of 1999-2007 and 2007-today CPI change:
It is visible that after the Credit Crunch and the following recession of 2008, the CPIs of the US, the Eurozone and Japan did not change by much, as they slid well below the target level of 2% YoY most of the time:
Fourth, central banks’ large balance sheets, caused by their security purchases, expose them to losses when they eventually raise interest rates. Such raise will erode the value of the bonds they hold. Nevertheless, when conducted gently enough, this procedure can be a way out for the central bank to deflate its balance sheet through time.
The following chart summarizes the Fed and BOJ’s total assets divided by total market capitalization from September 2003:
It is visible that the Fed’s assets have grown to be worth about one-fifth of the US total market capitalization, the highest from 2003, while the BOJ’s assets have jumped to be worth 56% of the total Japanese market cap.
Fifth, as QE increases the stock of money in the economy, it applies a force of depreciation of the national currency, increasing the competitiveness of its exporters on expense of its importers as another tool for encouraging price increases.
The following chart summarizes M1 money supply in the US, Eurozone and Japan since 31 December 2007:
It is visible that M1 has increased by three-fold in the US in less than seven years.
The following chart summarizes the foreign exchange value of the US dollar in relation to the Euro and the Yen from December 1999:
Other central banks react to a country’s actions to devalue its currency, and execute their own measures. This creates a race to the bottom called “currency war”, and has been gaining pace in recent years, with central banks ever-strongly intervene in foreign exchange markets to influence their currency.
Lastly, on a philosophical level, by reducing the overall expected risk-return ratio in the financial markets, QE has pulled wealth back from the future to the present day, harming savers which paid for today’s rescue with future lower dispensable income.
Central banks are walking a thin line, balancing between the forces they are mandated to influence. This causes uncertainty in the markets, which grow ever more dependent on the central banks’ actions for their effective operation. What are the costs of such strong influence by central banks on the free markets?
It seems that the central banks’ growing part in financial markets increases the mutual reliance between them, amplifies the influence of central banks’ actions on the real economy, and vice versa.
First, this larger mutual dependence between central banks and financial markets causes passive investments which track indexes (which by themselves reward companies for just being a part of a respectable club) to be particularly vulnerable to shifts in policy and stagnating markets.
Second, and perhaps more importantly, this may hint the existence of a reflexive relationship, following a usual boom-bust pattern, as George Soros identified 30 years ago.
Lastly, central banks’ current influence on the financial markets effectively reduces their level of freedom. Reduced freedom leads to reduced efficiency, a defective price mechanism and other unwanted results, which translate to a less efficient distribution of capital and thus lower expected economic growth. Therefore, it may be that the future of investment lays with stock picking, which I believe will enjoy growing popularity, once again, in the coming years.
Source of the financial data in this article: Bloomberg.