As global interest rates fall to zero amid a deepening recession, central banks across the world are resorting to quantitative easing to help reflate their ailing economies.

In economics speak, quantitative easing is a monetary policy tool that allows central banks to boost money supply in the financial system by buying up assets such as government bonds and mortgage-backed securities.

In plain speak, it means central banks are using the printing press to create new money to buy up these assets.

Quantitative easing has not been widely practised in the past but it is almost synonymous with Japan which adopted this policy in 2001 after interest rates, already at zero, could go no lower in its bid to lift its economy out of the doldrums.

Now, quantitative easing is fast turning out be the battle cry of central banks for 2009, never mind that it hasn’t proved to be very effective in Japan. Since late last year, the big countries in the industrialised world have resorted to quantitative easing, led by the US Federal Reserve, where the policy rate is now between 0 and 0.25%.

Since then, Japan (which stopped quantitative easing in 2006), the UK, the euro zone and Switzerland have all jumped on the quantitative easing bandwagon. The US Fed last week said it was pumping another US$300 billion into the financial markets to buy long-term Treasury bills, on top of US$750 billion already committed last November to buy up assets.

While there is no certainty that quantitative easing will help reflate a world economy that is fast sinking into one of its worst recessions ever, central banks really have run out of ammunition to fight it, insofar as monetary policy tools are concerned.

The consequences of quantitative easing are falling bond yields and the creation of a bubble in the bond market, and currency devaluation. Devaluation is a certainty because additional money will dilute the value of every dollar that is already in the pocket.
Further down the road, a fallout is possibly even hyper-inflation, if the exit strategy is not well managed, given that the new money printed will have to be dealt with once recovery takes place.

But many economists are of the view that it is a gamble that must be taken, so long as it is undertaken to improve liquidity, improve the balance sheets of banking institutions and in the process, boost lending and restore consumption.

Yet, given that quantitative easing is going to be a key policy, going forward, global financial markets must be prepared to deal with the heightened volatility in the short term, given its impact on currencies and asset prices.

More importantly, such volatility is not good for cross-border trade and capital flows which, in turn, will hurt global economic recovery.

Indeed, the US dollar in the last six months has seen its ups and downs. Last week, a day after the quantitative easing was announced, the greenback fell against the euro, pound, Canadian dollar and other world majors.

It is also stirring a debate on whether in the long term, the US dollar’s status as a safe haven will be challenged.
The volatility and devaluation, though, could be good news for commodities such as gold and other precious metals, which are seen as the best hedge against inflation. Certainly, several investment gurus have singled out gold as the biggest beneficiary of quantitative easing.

At this stage, economists agree that inflation is not the immediate concern. DBS Research, in a report, says that inflation is not a short-term concern. “Certainly not in the short term, where people are more worried about falling prices, that is deflation… when prices start to percolate again, it will mean that banks are lending again and companies are borrowing and hiring. In short, we are out of the woods. Signs of inflation should be cheered, not feared,” says the research house.

Today, markets are already warning that quantitative easing is facilitating a competitive devaluation of major global currencies, a phenomenon where central banks are deliberately allowing their currencies to weaken to deter imports and boost exports.
For economies like Malaysia which are export-dependent, such a development does not bode well for an early recovery of their export performance. More significantly, the world is watching to see what China will do, obviously because it is the world’s largest exporter and because it is expected to lead the world out of the current recession.

The effectiveness of quantitative easing as a policy tool is still largely untested. Indeed, Japan has shown that the risks could outweigh the gains, when such a policy action resulted in the build-up of a bond bubble in 2003 and spawned a huge yen carry trade that started unravelling some three years ago.

What is really needed at this point is more coordinated policy actions by central banks across the world. In this regard, the Group of 20’s meeting in London from April 2 will be an important event to watch.