When, rather than how to do it, is the key.
With a lot of liquidity in the global financial system generated by the major central banking institutions engaging in quantitative easing to support economic activities, asset prices have been driven higher, as the holders of such liquidity tried to earn a return on their money. Whether the rapid rise in, for example, the prices of financial assets is sustainable is a matter of conjecture; but I imagine investors would look at the economic fundamentals when making investment decisions. As I have pointed out before, these do not appear to be at all promising.
Perhaps investors should also carefully observe the attitude of the central banks towards quantitative easing. Certainly there has been more talk in the financial markets about exit strategies, and lately central bank officials have spoken at length on this subject, not so much giving any hint on the timing of the exit but more conveying the message that a strategy for a smooth exit does exist. Such communication is important for the financial markets. Obviously we hope that measures introduced during an unusual time can be removed in an orderly way when they are no longer needed, without undermining market stability.
Whether it is quantitative easing or the provision of liquidity support to the financial markets or financial institutions, these policies are manifested in a many-fold increase in the "reserve balance", or the total amount of money in the clearing accounts of banks held with the central bank. In the United States, the reserve balance now is nearly US$800 billion (it reached a peak exceeding US$930 billion in May 2009), compared with around US$50 billion before the collapse of Lehman Brothers. With a lot of money in the clearing accounts maintained by commercial banks in the US with the Federal Reserve, earning fairly low interest, the banks clearly have an incentive to lend the money to trustworthy borrowers. While banks can individually get rid of the money in their clearing accounts, collectively they cannot because they are all participants in a fixed-sum game and that fixed sum, the reserve balance, can only be varied when the central bank takes action to withdraw money from the interbank system. This is central banking in simple terms. So all eyes are now on when and how the Federal Reserve will reduce the reserve balance to a more normal level.
Federal Reserve officials have released a lot of information recently, but mainly on the how, rather than the when. And the how includes paying higher interest on the reserve balance, thus supplementing the Federal Funds Target Rate as a policy tool. This of course is not new, insofar as central banking policy tools are concerned. Many central banks, including the European Central Bank, the Bank of Japan, the Bank of Canada and the People's Bank of China, pay interest on the reserve balance. This is a way to restrain banks from lending and facilitate the exit from the easy monetary conditions. And there are other tools such as outright sales of securities, to the extent that the market is able to absorb them without threatening financial stability, or temporary sales of securities in the form of so-called reverse repos. Taking longer-term deposits from banks is another option. In any case, as the Fed reduces the scale of its different support facilities when circumstances permit, the reserve balance will come down. So there is no lack of tools. Timing though is another matter. The Federal Reserve will need to consider many factors, including developments relating to inflation, before implementing any exit strategies.
As I have pointed out before, Hong Kong is also engaging in quantitative easing, though indirectly through the persistent inflow of funds trying to position themselves to take advantage of the relatively attractive prospects of the Mainland and Hong Kong economies. The reserve balance, or what we call the Aggregate Balance, is currently well over HK$200 billion, compared with a normal level of around HK$500 million, which is enough in normal times for the banks to clear transactions among themselves using the efficient, real-time interbank clearing system, and given the fact that they are not subject to any reserve requirements. We in the HKMA have already prepared an exit strategy: in fact, under our rule-based Currency Board system, we do not have a lot of discretion in the matter. Much will depend on whether and when there is a reversal of the inflows.
Joseph Yam
13 August 2009
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