Banks responded to higher reserve requirements by reducing their lending and holding fewer bonds

TO BE NOTED: From the FT:

"Real risk in reversing money supply

By Edward Chancellor

Published: May 3 2009 14:16 | Last updated: May 3 2009 14:16

The recovery in the world’s stock markets has coincided with a bold monetary experiment. The aim of quantitative easing is to offset deflationary forces and free up credit markets. There’s a risk, however, that any gains enjoyed by investors today may be reversed when central banks remove the excess liquidity created by current emergency measures. Past attempts to soak up liquidity have produced varying degrees of pain.

Quantitative easing involves a forced increase in the money supply by the central banks. Investment strategists in the US and elsewhere have generally applauded this policy. Bonds should benefit from the appearance of a large price-insensitive purchaser, they say. Equities will gain as corporate financing costs decline.

Although US and UK government bonds have reversed some of their initial gains since quantitative easing was announced in early March, global stock markets have soared. Credit spreads on the riskiest corporate bonds have declined and the market for new high yield issues has reopened. Morgan Stanley notes that money supply is growing in countries that are implementing quantitative easing – a sign that the policy is gaining traction.

Everyone accepts that at some stage central banks will have to reverse this monetary experiment. Otherwise, excess bank reserves will fuel inflation.

Goldman Sachs economists argue that owing to the great slack in the global economy there will be no need to remove quantitative easing for several years. Besides, when the time comes to take away the monetary punchbowl, the Federal Reserve can simply allow many of the securities sitting on its balance sheet to mature and be paid off.

However, the central banks have recently been acquiring bonds with longer maturities. Any sudden attempt to remove excess liquidity by off-loading these bonds could roil the markets. If bond yields spiked higher, then heavily-indebted governments will see their fiscal position deteriorate rapidly. In short, there is a danger that the apparent gains from quantitative easing will be reversed when the policy is removed.

Two historical episodes suggest these concerns should be taken seriously. In the three years following the arrival of Franklin Roosevelt in Washington, US banks acquired large amounts of government bonds. Wary of lending to the private sector, banks accumulated vast excess reserves. By July 1936, these reserves had climbed to 18 per cent of deposits, nearly double the legal minimum.

By that date, deflation had abated and the US economy had recovered from the ravages of depression. Unemployment had halved from its peak and stocks were up more than threefold from their June 1932 low. However, wage rates were climbing rapidly. In the summer of 1936, the Fed decided to head off inflation. Over the following year, the banks’ minimum reserve ratio was doubled. It was believed that raising reserves would have little impact on the economy since banks would not have to sell their bond holdings and the provision of credit to the private sector would be unimpaired.

The outcome was rather different than expected. Banks responded to higher reserve requirements by reducing their lending and holding fewer bonds. Spreads on riskier corporate bonds doubled. In the 12 months after December 1936, the money supply contracted by 6 per cent.

During this “depression within a depression,” unemployment climbed back to 20 per cent, manufacturing collapsed, deflation reappeared and the stock market halved in value.

The Bank of Japan introduced quantitative easing in March 2001 and continued the policy for five years. During this period, excess reserves in the Japanese banking system climbed to Y25,000bn (£174bn, €194bn, $258bn). When the time came to remove this liquidity, the authorities feared a dramatic sell-off of government bonds, according to economist Andrew Hunt. A sudden rise in long-term rates threatened to derail the government’s finances. To reduce this risk, the fiscal deficit, equivalent to 6 per cent of GDP at the time, was forced back to surplus. Domestic demand softened markedly, while the removal of liquidity in Japan coincided with turmoil in the global financial markets in the early summer of 2006.

Most investors would consider Japan’s discomfort a small price to pay for the quantitative easing experiment. However, the US depression of 1937 suggests central banks will be wary when it comes reversing this policy.

Edward Chancellor is a member of GMO’s asset allocation team"