All you ever wanted to know about quantitative easing - and why you should care now

As is so often the case, when America sniffs, the rest of the world fears catching a cold and, in smaller and more vulnerable markets like ours, this quickly turns to concerns of a

full-scale bout of the flu. So, like it or not, South Africa needs to pay attention to QE and Bernanke’s pronouncements on its future.

But before going into detail on the current situation, it is prudent to take a step back in

order to understand QE and the reasons for its introduction in the United States.

In 2008, as the US battled the effects of what is now known as the Great Recession, it

became obvious that drastic measures were required to stabilise the tottering economy.

Bernanke and his colleagues at the Federal Reserve (the equivalent of the South African

Reserve Bank) decided on an unconventional, emergency, monetary policy consisting of two key elements: a reduction of the interest rate to its lowest level ever, which now sits at

between 0% and 0.25% and the introduction of quantitative easing.

In simple terms, QE is a way of increasing the amount of money in the economic system by

buying government or other securities from the market. This has the effect of improving

liquidity and also stimulating lending. But, while the amount of money in the economic

system is increased, it is not backed by gold or any economic activity.

QE is not something the US has done before and is not recommended in economic theory because of the potential repercussions Zimbabwe being a case in point a few years ago. The government simply printed money and the result was hyperinflation and the eventual collapse of the local currency.

The Federal Reserve’s approach to QE has been more sophisticated in that it has not physically printed more money but has created electronic balances. However, the impact effect is the same: you are creating more money in the system.

Bernanke’s strategy was implemented in three phases. QE1 came into effect at the height of the recession in 2008. QE2 followed, and we are now in the QE3 phase. Since inception, this has added a massive $2.7 trillion to the US economy and, at the moment, is adding $85 billion of additional money every month.

This enormous influx of funds has been used in two ways by the Federal Reserve. The first

was to buy government bonds – in other words, US government debt. The second was to purchase mortgage-backed securities, an asset-backed security that is secured by a collection of mortgages.

These instruments were, and continue to be, bought from the private banking system using the money created by QE which, because it was artificially created for this purpose and is not backed by anything, has the effect of putting more and more money into the economy.

The main reason for doing this has been to reduce the cost of mortgages and resuscitate

the housing market, which started to collapse in 2007 in what was known as the subprime

mortgage crisis and triggered the 2008/2009 recession. It is important to note that in the

US the cost of a mortgage is not dependant on the interest rate, as is the case in South

Africa, but on the government bond market – hence the need for the Federal Reserve to

buy government bonds.

As a result, housing has become more affordable and buyers have come back into the market. A US property recovery is unfolding, house prices are up 12% year-on-year and new homes are being built.

Because the problems in the banking and housing sectors are being addressed, businesses and consumers are feeling more confident and the recovery has broadened into almost every aspect of the US economy. While employment is still not back at the pre-recession level, 6.7 million of the 8.7 million jobs lost during the recession have been regained. The stock market has reached an all-time high, company profits are up and vehicle sales have almost fully recovered.

Given this positive outlook, Bernanke hinted at a press conference in Washington DC in

June that central bankers might, by the end of the year, slow the pace of the programme

with a view to stop sometime in mid-2014. What is unknown at this stage is how the phasing out will work. Will it be reduced by a set figure each month, for example?

It was inevitable that, at some point after five years of QE, the strategy would need to

be slowed and eventually stopped, so as to avoid possible longer term distortions to the

economy and unintended consequences – like the hyperinflation we saw in Zimbabwe, or

erosion in the value of the currency caused by an oversupply.

So far there has been no sign of a problem and it is important to emphasise that Bernanke’s

intention seems to be to get the market used to the idea and then implement the reduction in a planned manner, tip-toeing out of QE rather than expecting the US economy to go cold turkey.

The difficulty for the markets – financial, equity, bond, property and others – is that

they have become used to quantitative easing and now it feels like a necessity. Think of it

as someone who is learning to ice skate with another person holding her hand. At some

point the hand-holding needs to end and she must skate across the ice by herself, but as

that moment approaches, she is nervous and fears she may fall.

That is where the markets are right now; worried about what might happen once the Federal Reserve’s hand-holding ends. Can the US continue to recover without the benefit of QE? Will the housing market collapse again? What does it mean for global markets?

The bond market, which has been the main beneficiary of QE, has reacted with particular

nervousness and has been selling off. This includes South Africa, where our bond market – in common with others across the world – slavishly takes its cue from the US bond markets. Given that the markets are entirely different, it is a bizarre situation, but nevertheless a reality.

Our view is that Bernanke is correct in his assumption that now is the time to let go of the US economy’s hand. It is broad, stable and robust enough to withstand the withdrawal of QE, but that does not mean there is not nervousness.

For South Africa and other emerging markets, it is unfortunate that the Federal Reserve’s withdrawal of QE comes at the same time that economists and investors are revising their once-bullish views of emerging market economies in general. For years, these markets have been seen as a kind of golden boy. Some of the BRICS economies were forecast to achieve growth rates of 6%, and it seemed to many that an unstoppable success story was unfolding.

But in the last three to six months this vision has been questioned, as emerging markets

have slowed and performance has not been as robust as anticipated. We saw the rand drop to more than R10 to the dollar, but was not alone as Indonesia, Turkey, Brazil, Russia and India all dipped in similar fashion.

South Africa is now experiencing a significant bout of currency weakness, which creates risk because our inflation rate could potentially rise. It also means that, as a nation, we need to relook our economic parameters and the strategies we require to grow this economy.

However, the root cause has been uncertainty as to the fate of QE in the United States. Once Bernanke provides clarity and a firm timetable for reducing or stopping QE, we can expect further global market uncertainty. However, as the US economy proves itself to be a skater who can stay upright on the ice and grow without QE’s hand-holding, we think there will be a

return to confidence at the end of 2014.

At that stage we are hoping Europe will be doing better, Japan will have improved and the world economy as a whole would have picked up and started to lift South Africa’s growth rate from the present very mediocre 2%.