The Federal Reserve's second round of quantitative easing of USD 600 billion to support the struggling US economy was announced. This announcement by the Fed is almost in line with market expectations. The Fed announced it will buy treasury bonds of around USD 75 billion per month for the next eight months to increase money supply in the system as part of this quantitative easing.
This increase in money supply by increasing the excess reserves of the banking system is expected to keep the interest rates very low, and stimulate the borrowing and spending activities in the economy.
Need for quantitative easing
The US economy has come out of the 2008-09 recession but the economic growth rate has been very slow over the last few quarters. This is evident from various economic data points released month over month. On the other hand, new job creations are also very slow which is evident from the high jobless rate (hovering around 10 percent).
Economists believe there are chances that a continued high unemployment rate may lead to changes in consumer behaviour and therefore trigger another round of recession which could probably last much longer than the current recession. Therefore, the Fed is under pressure to take the required steps and provide another round of triggers to stimulate business activity.
Impact of quantitative easing:
Momentum for economic activity
The logic behind the quantitative easing is the Fed buys treasury bonds from banks leaving them with cash surplus to lend to customers. The interest rates would fall further and lower interest rates will encourage people to borrow money and increase spending. On the other hand, lower interest yield will discourage investors from investing in safer instruments such as bonds and debt instruments. Instead, they will invest in high returns investments like stocks. More spending results in more business and more hiring ensues.
High inflation
Inflation will certainly be a threat after this quantitative easing. Some economists believe the quantitative easing will increase liquidity in the system which may push inflation rate to higher levels. The high liquidity may result in a situation of excess money chasing limited resources and hence prices start going up, leading to a high inflation rate.
However, inflation is under control at the moment and the Federal Reserve is not very worried if it goes upwards slightly.
Weak dollar
The quantitative easing will result in a drop in interest rates, and as a result the dollar will have some depreciation in its value against major world currencies in the international market. However, analysts believe the quantitative easing package of 600 billion dollars will not have any drastic impact on the dollar valuation. The US dollar will eventually regain its strength in a couple of quarters, the feel.
Increased inflows for emerging markets
The quantitative easing will result in further funds inflows into emerging markets such as India. Analysts believe a part of this excess cash will be channelled to the emerging markets as these countries are better positioned than their developed counterparts in terms of economic growth.
In the markets here, foreign institutional investor (FII) inflows are expected to remain strong in the short to medium terms. This will keep the markets in a bullish momentum.
On the flip side, this will mean challenges related to high liquidity, and the high inflation rate will continue further up. Sharp currency movement is another factor which investors should track going forward. Individual investors should not turn over-optimistic on the stock markets, but exercise caution.
