PARIS (MNI) – As the US Federal Reserve moves towards a fateful
decision on whether to launch another round of quantitative easing,
central bankers in Europe are watching and waiting with trepidation.
Given the sensitivity of such a move by the Fed and its potential
implications for the global financial system, Eurosystem policymakers
are extremely reluctant to discuss it publicly. But in private
conversations, their apprehension is palpable.
Some of them say another round of QE in the U.S. could send a
message of desperation and weakness, which financial markets might
pounce on. Others argue that more QE would be of limited effectiveness
and likely do more harm than good — especially later on, when the Fed
pulls the plug and market rates begin to rise again.
Still others say that by launching what is now widely referred to
as QE2, the Fed would be entering unchartered waters in which the
consequences are hard to predict or control.
More important for Europe, monetary policymakers in the Eurozone
argue that despite repeated declarations by U.S. officials in favor of a
strong dollar, QE2 would in fact amount to a kind of backdoor currency
devaluation. Though recent reports suggest that QE2 may end up being
more moderate than feared, additional easing will nonetheless keep
downward pressure on the dollar.
“It is very similar to FX intervention,” said a well-placed
Eurosystem source. “Since there are very [few] risks of deflation, the
attempt is to distort asset prices to encourage consumption — but this
would be artificial.”
One senior official lamented, “Despite the fact that the US
government reiterated its commitment for a strong dollar, we have
indications that the Fed is readying a second round of monetary
intervention via quantitative easing.”
Along with China’s reluctance to revalue the yuan and the potential
for more currency intervention by the Bank of Japan to push the yen
down, this creates “increased worries for the ECB, which sees the euro
climbing to a foreign exchange parity that is not reflecting the
European economic fundamentals,” the senior official said.
“But at the same time,” he added, “we are not prepared to intervene
in the forex market and we call on our counterparts to honor their
commitment to avoid creating volatility in the foreign exchange market.”
Some of the officials contacted by MNI were not entirely convinced
that QE2 would necessarily exert additional upward pressure on the euro,
since much of its effect may already have been discounted by the market.
And a third well-placed Eurosystem central banker noted that Japan has
been through more than one round of quantitative easing and is still
stuck with a strong currency.
Nonetheless, there “is a fear” that the euro would shoulder the
burden of US quantitative easing globally in light of China’s “go-slow”
on foreign exchange policy, this official observed.
However, he said that the most worrisome aspect of QE2 is what it
would suggest about the state of the economy — and the state of mind of
policymakers — in the United States.
“It’s worrying that the U.S. is heading down this road,” he said.
“One of the more worrying factors of a second round of QE could be the
signal that it sends,” he added. “Does it suggest that US policymakers
fear that the United States might, like Japan before it, be heading into
a lost decade? What have they seen in the numbers?”
He also expressed concern that markets could view it as “a last
throw of the dice, and if markets sense desperation, they tend to go for
the jugular.”
But the first source downplayed that danger, saying “markets have
likely discounted” an announcement by the Fed already. “I think that
[Federal Reserve Board Chairman Ben] Bernanke is more concerned about
this point,” he added. “But he is getting overtaken by extremists such
as [Fed Vice Chairwoman] Janet Yellen.”
Of more concern to this official is that “there is an issue of
credibility for the Fed…And sooner or later they will have to exit,
which will give a hit to bond holders and banks, as in 1994.” He was
referring to the episode 16 years ago, when abrupt rate hikes by the Fed
led to the worst bond market losses in history, inflicting severe damage
on financial companies.
It is not an absolute certainty that the Fed will pull the trigger
on QE2, or at least not as soon as many believe. Most Fed watchers,
including those in Eurosystem policy circles, will be closely watching
the next FOMC meeting on November 3, and many believe the Fed will take
the plunge then.
It is possible — and in Europe, as well as in many emerging market
countries, it is fervently desired — that the Fed’s actions will be
tempered by the recent G20 statement, which pledges that “advanced
economies, including those with reserve currencies, will be vigilant
against excess volatility and disorderly movements in exchange rates.”
It is even more likely to be tempered by the arguments of those FOMC
members who actually share some of the concerns of their European
counterparts.
Markets are nonetheless expecting some form of QE2 to be announced
next week, though recent reports put the number at only a few hundred
billion dollars. This is less than the $500 billion figure that was
making the rounds earlier, and it is only a sliver of the $2 to $4
trillion that some analysts have said would be needed to make a tangible
economic impact.
Eurozone central bankers, like markets, are pretty much convinced
that some form of QE2 is on the way, as much as they regret it.
“In my view, the quantitative easing is unavoidable, given the
latest economic data of the US economy,” said the senior official.
The first Eurosystem source was more nuanced, though he also said
QE2 was more likely than not.
“I don’t think it is a done deal, but they are under political
pressure to do something to stimulate growth,” he said. “That is their
main concern. Even if it is not very effective, they think that at the
margin it [does] no damage.” He added: “They may not be seeing the
negatives as much as we do.”
Among those negatives is the simple fact that in setting out on
this course, the Fed could be entering the unknown — an uncomfortable
adventure for central bankers, who tend to like predictability.
“Embarking on QE2 is totally new ground,” the third official
asserted. “It’s an experimental tool box that’s being opened.”
By buying more bonds, the Fed is essentially saying it wants more
inflation, he argued. “Will inflation targets overshoot? What will the
targets be? If they do overshoot, how to control them if growth doesn’t
respond?”
–Paris newsroom, +331-43-71-55-40; paris@marketnews.com
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