The pros and cons of quantitative easing
One of the good things to come from the recent global financial meltdown is the man in the street suddenly has an interest in economics. Everyone is talking about supply and demand. And you can drop the phrases sub-prime, credit bubble or negative equity at the dinner table without causing confusion. The economic term of the week is quantitative easing. It caught our attention after the 4 November 2010 announcement by the US Federal Reserve that they would dedicate $600 billion to the task… What exactly is quantitative easing?
Investopedia.com, a website dedicated to financial terminology, defines the concept as follows: Quantitative easing is a government monetary policy intervention occasionally used to increase the money supply by buying government securities or other securities from the market. The US Federal Reserve is going to “print” money and throw bucket loads of “greenbacks” at local financial institutions to boost lending and liquidity. Now we know what quantitative easing we can ask a more telling question: Why quantitative easing?
A last ditch attempt to ward off deflation?
The $600 billion bailout (called QE2) is really a last ditch effort to ward off deflation. Investopedia.com expands on the statement as follows: Central banks use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect. In other words – the US has cut interest rates to the bare bones without the desired economic effect. Think about it for a moment. After spending $1.8 trillion through 2009/10 (QE1) on all manner of financial institution rescue packages and consumer incentives the US government has nothing to show but a fragile – and painfully slow – economic recovery. Corporate earnings have turned the corner, but real economic measures such as employment and housing remain pitiful. Thus enters the “catch 22” economists are faced with daily.
If the US government stands back and does nothing then the economy could enter a period of severe deflation. Prices will fall – company revenues will decline – job losses will continue unabated and GDP growth will crawl back into the proverbial shell… On the other hand – the flood of “money” could send inflation through the roof – and either put the brakes on economic recovery or create another asset “bubble”. Hilton Davies of SA Bullion Management says the latest intervention has many possible consequences. These include a depreciating dollar, jitters among foreign holders of US treasuries, yield-hungry cash exiting the US for emerging markets and soaring commodity prices.
Consequences for South Africa
Plenty of this short-term “cash” is finding its way to South Africa, with foreign investors clamouring for local equities and bonds. The massive inflow of foreign capital is certainly impacting the domestic economy. It ensures continued demand for the South African rand, with the result our currency is overvalued by quite some margin, currently changing hands at around R6.80 to the dollar. It also props up locally listed companies, whether the economic fundamentals warrant it or not.
The biggest consequence of developed world quantitative easing (Japan has plans to echo the US soon) is the surge in the gold price. Gold jumped $14.50/ounce the day the Federal Reserve made its announcement – and smashed to a new all-time high of $1407/ounce in London last night and to $1411/ounce this morning, 9 November 2010. That’s why gold guru, Martin Murenbeeld, says gold will surge higher until at least 2012. His probability-weighted forecast points to a $1 335/ounce average in Q4 2010, rising to a $1 592/ounce average in Q2 2012.
What can investors do to ride out the storm?
Davies says the risk of massive inflation in the US and other industrialized nations in the next few years is extremely high. He singles out currency risk as one of the major risks to international investors in these difficult times. As such, he recommends “owning some gold”. Old school investors will probably add to their stockpile of Krugerrands, while the new school can get on the horn to their stockbrokers and pick up a few units in the New Gold Issuer Limited (JSE: GLD) exchange traded fund.
Editor’s thoughts: Nobody talks up the price of gold better than a gold bull. Murenbeeld told delegates at a recent Denver Gold Forum he had nine pros and six cons for the precious metal… But the cons were simply “less potent” than the pros over the short-term. Are you tempted by all the “golden” arguments doing the rounds right now – or do you prefer to stick with “bricks and mortar” investments? Add your comment below, or send it to gareth@fanews.co.za
