Friday, September 21, 2012

Too much is too bad!?

Massive injection of stimulus by world's largest central banks is the highlight of the week.  European Central Bank has pledged to buy debt from Euro zone countries to contain borrowing costs earlier this month.  This was followed by US Federal Reserve's open ended QE3 (announced last week) through which the central bank would buy $ 40 billion a month in mortgage backed securities until the economy recovers. BOJ's decision to opt for easy money policy is not only to give impetus to ailing economy but also stop yen from appreciating any further to help protect country's exporters. It's highly likely that Bank of England would soon unveil additional measures to stimulate growth.  

The ultimate goal of intervention by central banks is to be able to influence prices and return on financial assets and hope to have an impact on businesses by lowering borrowing costs and also encourage households to spend in order to boost the economy.  Inflation and asset price bubble (triggered by easing) are concerns but global economy that is on life support currently is a bigger concern. Concerted effort by major central banks increases the potency and this time around we may see demand getting spurred. Investors and financial markets across the globe have been exuberant and they expect central banks' actions to play out for considerably long period. 

What is quantitative easing? Central bank plays an active role in the economic and financial functioning of it's country through monetary tools.  Most widely used tool is setting short-term interest rates in order to influence economic trends.  As we all know low rate policy is prescribed when growth needs to be stimulated and interest rates are set higher when inflation needs to be contained.  Growth is the need of the hour; however Federal Reserve for one has set the interest rate close to zero (for some time now) leaving no room for further reduction to boost growth.  The next  available option is to pump more cash into the system.  This cash is intended to buy bonds and financial assets from banks, leaving the banks liquid so they in turn justify their existence by continuing to lend to businesses.  Business expansion is expected to result in increased employment opportunities and everyone lives happily ever after; well, at least in an ideal world.  

How is easy money elsewhere, is affecting us at home? Since last week, amid flurry of freebies from central banks, Indian equities and Rupee have been beneficiaries.  Investors are flocking to countries and assets which promise more attractive returns than rock bottom rates offered by the US, Euro zone and Japan.  Now with the promise of printing money to infinity (well, close to it), there is more cash (likely) chasing Indian and other emerging market assets.  This hot money would push our central bank to review it's monetary policy in order to (1) keep inflation at bay which is an immediate concern (2) fight against untoward rupee appreciation (as and when).  

Will the easy money push inflation up in US and Euro Zone without any positive impact on demand and output?  Once the factory activity is in full swing and unemployment is under an acceptable level, it is more likely that  (continued) monetary stimulus could prove to be inflationary.  It looks like we are quite a few quarters (if not years) away to get there.  Till then, too much money doesn't seem too bad, honey!

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