The US Interest Rate decision, due this evening at 19.15, is widely expected to be a cut of 0.5%, bringing the rate down to 0.5%. No doubt tomorrow we will see a raft of headlines announcing rates have hit the lowest levels that anyone in this generation has ever seen. The race to Zero Interest Rate Policy (ZIRP) will most likely also garner some column inches. In reality however the effective Fed Funding rate is already about 0.125%. So the rate cut is largely symbolic. And what it symbolises is that the Fed’s interest rate ammo is spent. What few rate cuts that may be left cannot be expected to improve the economy; other tools must be used.

This is why I’ll be paying more attention to the statement following the meeting than the decision itself. And I’ll be watching for one key phrase: ‘Quantitative Easing’. This isn’t a simple concept, but it is important and could have consequences for years to come

Cash Hoarding
One of the reasons for the oncoming recession is ‘cash hording’. As companies, hedge funds and even households worry about the source of their next loan they have started to raise cash via ‘forced liquidation’, i.e. selling any asset which can be quickly converted into cash – even if this means taking a loss. The persistent decline in equity prices and commodities of late is but one example of this process. Meanwhile, any cash that people do have is being hoarded. Why spend money if you don’t know where your working capital or export credit will come from? In simple terms, what we’re seeing is a vast increase in the demand for money to be held rather than spent.

A Bit of Theory – The Fisher Equation
To understand what is going on it’s worth reminding ourselves of Irving Fisher’s neoclassical theory of Money Supply, Money Velocity and GDP. A chap called John Mauldin has written an excellent intro, from which I’ve cut bits out and pasted the rest below – but if you are happy with these concepts skip downwards.

Let’s assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our “gross domestic product” from a money supply of just $100. If we do that transaction every month, we would have $2400 of annual “GDP” from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply but how fast the money supply moves through the economy. Stated as an equation, it is P=MV, where P is the Nominal Gross Domestic Product (not inflation adjusted here), M is the money supply and V is the velocity of money.

Now, let’s complicate our illustration a bit. Let’s assume an island economy with ten businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the Gross Domestic Product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of new products, new production capacity etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month.

Now let’s complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. In order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. If velocity stays at 12, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. In that world, the local central bank recognizes that the money supply needs to grow at some rate.

So, the relevant equation here is P=MV, where
P = Nominal GDP (i.e. economic growth)
M = the stock of money i.e. the amount of money in circulation
V = its velocity i.e. how many times it changes hands

Right, back to quantitative easing. As I said above, businesses, banks and individuals are hoarding cash. The problem with all this hoarding is that V, the velocity of circulation of money, is collapsing. This is in part a reaction to fears that M is on the way down, because of banks’ inability to maintain loan volumes. If V collapses, P (or GDP) is in danger of collapsing as well.

How do we get out of this mess? Either M (the stock of money) has to rise dramatically to offset the decline in V or V itself has to rebound. However while banks are refusing to lend, the chances of V bouncing back are slim. So the answer sadly has to be a much bigger role for the government.

Quantitative Easing
Our economic system is based on governments borrowing (issuing debt) from various parties, including private players like pension funds and other countries’ central banks (via soverign wealth funds).

However now some governments (notably the US but include the UK and Japan here too) have been quietly muttering about having their own central banks buy the debt they issue. As a policy it would be largely untried and untested (apart from Japan in the late 1990s – see below). Nevertheless the central banks, having run out of interest rate cuts or seen them have little effect, may feel they have few options left.

The Mechanics
How does ‘Quantitative Easing’ work? Let’s take the USA as an example:
The government issues debt – Treasury bonds. Some of these bonds are bought by the usual sources. However some are also bought by the Federal Reserve – a process called ‘monetizing the debt’.

Where does the Federal Reserve find the money to do this? Easy – as they are a central bank they can simply ‘create’ the money.

Why would the Federal Reserve take such an exceptional step? Currently the US government (and they are far from alone in this) are having to fund some very big bailout plans. To do this they are issuing more debt or, to put it another way, they are increasing the supply of debt. Right now the demand for debt has also gone up, which means prices have stayed high (and yields have stayed low). However if the demand were to reduce then prices would fall, which could:
a) lead to some of the major holders of US treasuries to start selling them, forcing price lower and yields higher.
b) lead to an increase in the rates that corporates and others would have to pay for their loans, which would slow any economic recovery.
By purchasing Treasury Bonds themselves the Fed would be able push down longer-term interest rates, making longer-term funding cheaper.

The second reason for this action is it puts a lot of money into the pockets of the government, who can then spend in an attempt to restart the economy.

What Happened In Japan?
The Japanese used this technique in the late 1990s and early into this century. There they bought their own long-term debt and did manage to hold long-term interest rates down to a level below where they would have otherwise been. However the Japanese authorities simply held on to the money rather than spend it. The scheme’s success was debatable.

Back To Fisher
In Fisher terms, monetising government debt would both increase M (because the central bank would effectively print money for the government to spend) and V (because by pushing long-term lending rates down it becomes easier for companies to borrow and spend).

As discussed above, if the government can borrow more than would otherwise be the case and then spend the money via bailouts, by increasing ‘public works’ spending or even by lending directly to companies it again increases V.

What Are The Risks
Any massive increase in money supply, such as the one we are talking about, could fuel inflation. Right now deflation is the short-term worry – however the in the longer term inflation could get out of hand.

Some have speculated that, by forcing long-term interest rates downwards, the Fed will be creating the environment for a bubble in the future. After all, they say, holding short-term interest rates down from 2001 to 2004 contributed to the consumer spending and housing bubbles in the US that have now burst.

The most significant ‘known’ risk is that the government manages to push money back into the pockets of companies and individuals but each of these decided to simply either save it or pay down existing debt. As a result the economy ‘kick-start’ fails.

However as this form of ‘Quantitative Easing’ is largely untried and untested, the greatest risk is the risk of the unknown.

Any Other Options?
Alternatives do exist. The government can either take control of the banking system through total nationalisation or, instead, create a public sector banking system to operate alongside the depressed private sector system.

Market Reaction
How the markets will react to an announcement of ‘Quantitative Easing’ is far from clear.

Firstly, as we are now so close to Christmas I doubt that Bernanke will be specific in his plans. Too much detail could cause havoc in the bond market. However a strong hint at ‘Quantitative Easing’ would be bearish for the dollar in short term.

After the US has taken the first step towards ‘Quantitative Easing’ things could play out in any number of directions. However the most likely scenario for me is that the Bank Of England and Bank Of Japan follow suit and announce plans of their own. Again this would be bearish for their currencies, although how bearish depends on whether they go the full hog or adopt ‘limited ‘Quantitative Easing’ (which seems more likey to me). My guess is the ECB will be the last to react and so the Euro will strengthen.

If the plan works then US economy will be the first to emerge form recession, so in the long term the plan may eventually be bullish for the dollar.