The doves are right on third round of US QE

The third round of quantitative easing (QE3) recently announced by the Federal Reserve has sparked more or less the same reaction as the first two rounds, which started in 2008-09 and 2010 respectively.

On the one hand, hawks argue that quantitative easing – creating money to purchase assets – debases the dollar and risks extreme inflation. On the other hand, doves argue that with deflation and a renewed financial crisis lurking, almost no amount of money printing is likely to be enough.

Economists have wheeled both arguments out at every stage of the US QE saga. The general impression has been of an even-handed debate. As the financial markets have short memories, however, it is often forgotten that each round of US QE was launched under very different economic circumstances. A one-size-fits-all dogmatic approach as to whether the latest round of QE is right or wrong is inappropriate. QE is sometimes a helpful tool. At other times, it is counterproductive.

The first round of US QE – creating money to purchase government bonds and asset-backed securities from financial institutions – was an undeniable success. The money supply was reversing. Institutions had too little left in reserve. The market for asset-backed securities, most particularly mortgage-backed securities, had dried up. The government was propping up the financial system, and yet it was massively indebted. QE was an absolute necessity. The doves were proved right.

The second round of US QE (QE2) – creating $75bn (£46bn) a month to buy US government debt only – was a poor idea. Both the money supply and institutions were in decent shape. Demand for treasuries was solid. All QE2 created was inflation and an excessive wad of new cash, which rocketed counterproductively into fast-growing emerging markets. Given the economic circumstances of the time, the hawks had the upper hand.

With the hawk/doves scoreline 1-1, the Fed has launched QE3 – under another completely new set of conditions. The world is in a slowdown. Inflation is slipping. US economic growth is steady but vulnerable. As last year’s negotiations over US government debts proved, US politicians are incapable of coming to an agreement and may well let the US career over its fiscal cliff – scheduled tax rises and spending cuts – early next year. Even if it doesn’t, the down-to-the-wire negotiations US lawmakers seem fond of will have a negative impact on economic sentiment.

QE3 therefore looks not only advisable but necessary. Moreover, the terms of QE3 are very different. The quantity of assets purchased will be only $40bn a month, rather than $75bn under QE2. The assets themselves will be mortgage-backed securities, not US government debt. US government debt is extremely well supported by the market, while the crucial US housing market has been undergoing further difficulties over the last 18 months. There is a danger other currencies will rise counter–productively against the dollar, but at $40bn a month this danger must be limited. I’d wager that after QE3, it’ll be 2-1 to the doves.

Nick Rice is editor of Investment Adviser