American Quantitative Easing & it's Implications

Certainly one of the biggest stories in financial markets over the past several months has been the US Federal Reserve’s (the Fed) decision to implement another round of monetary policy easing through what is termed quantitative easing, or in this case QE II.

The policy involves the Fed effectively printing new money, in this case $600 billion, then using the funds to purchase US government bonds in an effort to lower interest rates. The lower interest rates reduce the burden on borrowers which, in theory, entices savers to move their funds from low yielding investments, spending some and investing some in higher return investments such as stocks. Through this process asset prices rise and people feel wealthier, which further encourages them to spend and invest. In short, it is a B12 shot in the arm of the economy.

It sounds simple enough, and while the Fed is embarking on one of the more ambitious policies since its establishment, it does have risks. We won’t go into these in detail, but they include inflation, a loss of confidence in the US dollar as well as an expansion of the Fed’s balance sheet. The greatest risk is the measures simply don’t produce the desired effect, but once having fired its ammunition the Fed has reduced its ability to act in the future.

More importantly, for investors in Australia, what are we to make of the Fed’s strategy? I think we can say that, at least in the initial stages, further stimulus by the Fed will result in stronger demand for so-called risk assets. These may include global equities but, crucially for Australia, commodities. Already, these prices have been supported by strong demand from Asia, but the actions of the Fed can only add to this demand.

As we have indicated in previous Perspectives articles, we fully recognise the growth profile of Asia and the beneficial impact this will have on commodities; introducing the Fed’s actions into the equation adds another dimension.

While it’s too early to make a call on the quality of the Fed’s QE II policy, we believe the US economy is well on the road to recovery and this policy, whilst containing some risks could be a further catalyst for renewed American consumption and investment activity.

Peter Reed, February 2011