Quantitative Easing (QE-2) by FED

Breaking the psychological barrier of eleven thousand in the DJIA index this week, surge in commodity markets, weakening of US Dollar globally against major currencies, pressure on global economies to stabilize their currency rates, emerging markets finding easy-money policies in the developed world a challenge, fear of hyperinflation at home are all results of several fiscal measures taken by major economies and notably one that is taken by Federal Reserve (FED) called Quantitative Easing in Short (QE) and another one anticipated in early November, 2010 estimated between $500 billions to $1.2 trillions all in the game to come out of recession and possibly to avoid double dip.

What is Quantitative Easing (QE)
Financial Regulators have several arsenal of tools at their disposal to stimulate and regulate the markets. QE is a monetary policy used by Central Banks to stimulate the economy by increasing the money supply when interest rates are near zero and need another tool to stimulate the economy.

How does it work
Central Banks first credits its own account with money from nothing,  and then purchases bonds from financial institutions, government treasuries, corporate bonds thus infusing money supply in the hands of financial institutions. The new purchases by way of new account deposits,  provides the 'excess reserve' required for them to create new money in a multiplier factor in the fractional reserve banking system (For example 10% reserve requirement means for every $10,000 created by QE can potentially create $100,000).

Central banks controls "Interest rates"  or "Reserve Requirements" to indirectly influence the supply of money in the economy inflation or deflation situations. Some times keeping the interest low may not just be sufficient and that may lead them to resort to Quantitative Easing. "Quantitative" because they specify a number to work which is generally large and "Easing" refers to reduction of pressure on banks.

FED is not the first one which adopted this technique. It was first used by Japan in early 2000 to fight domestic deflation, while Bank of England used this method at the same time as US Federal Reserve in 2008, to stimulate and alleviate its economy. The QE positive impact of flooding with excess liquidity enables commercial banks to continue to provide private lending while still maintaining and retaining excess reserves to avoid any liquidity shortage durig these tough periods. The depressing interest yield on Government bonds, and similar instruments, make it cheaper to raise capital. Besides, Investors could potentially swap their investment strategies favorably towards equities and thus boosting the share prices and thus revive towards increasing the wealth in the economy.

On negative side, the major concern is about hyperinflation with currency loosing its value in the Global market, which is often measured in much shorter intervals like months rather than a year. Some economists also believe that once this scenario sets in,  it is tough to control in the short interval and could take years to stabilize as it happened with Japan. Also, Banks may opt to sit on the excess reserves rather than lend if they think its much more riskier to lend as it happened earlier in 2008. (QE-1 of Fed's credit easing produced $670 billion of excess reserves at banks and financial institutions which works out to around 4.7% of the nation's annualized GDP). We may also see flight of currency to newer destinations like Brazil to earn higher bond yields than US, Europe and Japan because of rock bottom rates.(Brazil this week to stop the inflow of foreign currency doubled its Tax rate on foreign investment in certain Brazilian bonds and increased the amount its Central Banks can intervene in Currency markets).

In the coming months we could see turmoil and pressure on major currencies of  China's Yuan, Israel's Sheqel, South Koreans Won, Brazil's Real, South African Rand, Indonesia Rupiah, Australian Dollar, Swiss Franc against US dollar and worsening tensions among Euro currency and of other 24 Emerging and developing nations with each trying to keep their currencies weak to keep exports competitive because of Quantitative Easing by US.

QE's current impact

• Last week dollar fell 7% against major basket of currencies for total fall of 21% this year.
• Investors are moving into Equity market resulting in 11,000+ DJIA 
• Investors are moving to commodities mainly metal resulting in all time high on Gold & Silver prices creating a bubble scenario.
• Flight of currencies to other countries like South Africa, Indonesia, Brazil, Israel because of near zero interest rates at home.
• QE-1's trillions of dollar has not yet been burned and the likely infusion of another trillion in QE-2 by FED has market up in arms.

The "Currency War" as described by Brazil's finance minister Guido Mantega last week may not be correct description but perhaps if global leaders continue to take unilateral and unconditional actions one may see some potential out of control situations in the foreign exchange market. Remember it was not long ago, we saw major economic issues with European countries of Greek, Spain that needed bailout,  and EU and IMF intervened to pump in  €110b to stabilize their economies and we are continuing to see other countries like Ireland all needing a coordinated help to ease pressure in the world market.