The document discusses the effects of the Federal Reserve reducing its $85 billion per month bond buying program. It notes that reductions in bond purchases can transmit to housing booms and busts which then impact banks and financial institutions. The document also discusses how quantitative easing (QE) has lowered yields, risk premiums, and increased wealth, but that real economic growth in the US is not happening fast enough. It questions whether large scale central bank asset purchases could lead to future financial bubbles or global currency and trade impacts. The conclusion is that developed economies must create real wealth rather than rely on nominal growth, and that banks will need to change their role in funding growth rather than asset bubbles.

1. Effects of End of QE
Global impact of a reduction in the $85/month bond
buying by Fed

2. Housing – Finance Link
— Booms and bust transmit directly to banks and financial
institutions;
— 1973-1975 [UK-US]
— 1991-2 End of S&L boom, insurers & banks in mortgages
— 2006-2009 Repeal of Glass Steagall, disintermediation, alternative
banks originate distribute high LTV and subprime securitized loans.
— Nominal rates rise, to counteract INFLATION;
— BUT 2007-2009…. SOLVENCY CRISIS means interest rates have
to go down to almost ZERO in nominal terms, negative in real
terms. Classic Liquidity trap, case study for economics
undergraduate course!
— Credit dries up. Loans from banks SHRINK money supply by over
$1.0 trillion……..

3. The Fed and QE

4. Interest rate transmission
to real economy…
— Ration cash between today and tomorrow consumption/
investment, [instant gratification];
— Prices at different times horizons, based on yield curve;
— Marginal Productivity of investment > 1;
— Low interest rates increase investment… But if there is
massive EXCESS capacity… then cash is hoarded;
— Wealth effect, lower rates, lower income from financial
assets…. Increases net worth/liabilities;
— Currency depreciates, but can be offset by FDI.

5. Because of credit default fear. Hard asset that can be moved
easily and retains its value.
Why is Gold up?
— Gold price has been up dramatically

6. $85 billion in bond and asset purchases per month 6
US Fed Reserve

7. Huge growth in assets as a result of bank bailouts.
Bank of England
— Assets: (source: the Bank of England)

8. Interest rate concepts
— Nominal vs. Real. In the real world there is no money
illusion;
— Which inflation rate? Headline.. All “index baskets” are
constantly adjusted…
— Zero bound nominal rates… Deflation, liquidity trap..
— Yield curve changes affect saving investment horizions;
— Interest rates include a element of risk premium;
— Credit;
— Risk implied in asset returns….

9. Risk transmission
— R = β[ 1 + Φ]
— R = risk adjusted rate;
— β= risk weighting;
— Φ = return on long term sovereign debt, assumed to be risk free.
— β=1 is risk neutrality;
— β>1 is risk aversion;
— β<1 is risk seeking, gambling…
— BUT!!!!!! This explanation breaks down when sovereign risk is
not risk free, as we saw in the Greek crisis…..

10. Monetary Policy Impotence
— When 30 year treasury rates = 2.95%;
— Lending at banks shrinks by >$1.0 trillion, Fed takes up only 0.6 of slack;
— QE transmission out of US economy, in essence back stops growth in EMERGING
markets, not US;
— Unconventional monetary policy: Central bank can buy anything to create bank
reserves, high powered money [H], [through money multiplier];
— EFFECTS OF QE:
— Lower yield’s across yield curve;
— Lower risk premiums ~ improving liquidity;
— Increase Wealth;
— Increase Ms and H. This can increase lending but really has not as corporations
hoard cash, buy back shares.
— REAL ECONOMY GROWTH…. It is not happening fast enough……

11. Hazard of large scale assets of
central banks
— International financial system stabilities, but is
drugged by Ms and H from Central banks;
— Financial assets bubble in the future? Or is it a
crucial stop gap to prevent deflation… If so the
financial system is inherently UNSTABLE (complex
time lag);
— Changes US $ foreign exchange rates as reserve
currency and the term of trade.

12. Food price index up
— Food price index has been up since 2007 (Source:
Food and Agriculture organization of United Nation)

13. China CPI and Food Price
China CPI and Food price
0
2
4
6
8
10
12
14
16
2010-012010-032010-052010-072010-092010-112011-012011-032011-052011-072011-092011-112012-012012-032012-052012-072012-09
%
CPI
Food

14. Does QE cause inflation?
Printing money causes inflation only if the money
is lent & spent …
6.50
6.70
6.90
7.10
7.30
7.50
7.70
7.90
2008 2009 2010 2011 2012
$trn
0.0
0.5
1.0
1.5
2.0
2.5
3.0Money supply
(right axis)
Bank credit
(left axis)
Source: Gregory Ip, Economist. Shows the extent of bank solvency problem!

15. … or if expected inflation rises
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
2008 2009 2010 2011 2012
Expected inflation
Real bond yield
Source Gregory Ip, Economist

16. A lot of QE benefit swallowed up
Gap between mortgage rate paid by homeowner,
and yield on mortgage bond
Source: http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf

17. But seems to be working
Source: Gregory Ip Economist

18. QE monetary policy effect on recovery
— High food prices and high gas prices degrades
developing country consumer confidences on
the future
— Appreciated currencies of emerging markets
and declining demand of the western markets
impeded recovering economy of emerging
markets
— Currencies appreciation/depreciation for $,
Euro, Yen and C$ create new carry trades in
the recovery from this five-year recession

19. Has QE worked? a measure of x:
spread between corporate and Government bonds
Only in a temporary way
But: In the long run..
We are all dead!

20. Conclusion
— Democracies in advanced are addicted to nominal
growth, not real growth!
— Money supply has bought time for the adjustment
in living standards;
— Now it is up to developed world to create real
economy wealth, and that is very difficult in todays
economic environment;
— Banks role at center of developed economies will
have to change [= regulated], as have not been able
to fund growth, just asset bubble lending.