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Weekly Bank Research Center 12-01-08


The Fed’s Quantitative Easing (QE) Operations and the Dollar

Stephen Roach, Head Economist, Morgan Stanley

The Fed has commenced QE (quantitative easing). In this note, we review the concept of QE and analyse the likely impact of this extraordinary operation on the dollar. The upshot is that, since monetary policy, including QE, is a ‘nominal’ operation, the operation itself should not have significant implications for the real value of the dollar. The nominal dollar value should, thus, only be affected if QE alters the outlook of inflation in the US over the medium term. Also, whether QE by the Fed should erode the value of the dollar should be assessed relative to what other central banks do. To the extent that the ECB and the BoE also conduct QE – which is the case – the impact of QE on the dollar is not necessarily negative. Having said this, though QE per se should affect the dollar through relative inflation as well as inflation expectations, the underlying structural problems that forced the Fed to conduct QE in the first place should alter the fundamental value of the dollar, relative to those of other currencies. The parlous state of the US financial system should, in theory, be reflected in a lower value of the dollar, had it not been for its hegemonic reserve currency status propping the dollar up during this deleveraging phase. The bloated fiscal deficits (which we assume will exceed those of the G7 countries) will further weigh on the intrinsic value of the dollar.


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Rescue Packages vs. Economic Data

Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

The past week saw a series of initiatives from the world's central banks aimed at stabilising the situation in the financial markets. On Monday, a rescue package for banking giant Citigroup was passed, and on Tues-day the Fed declared its intention to buy up assets for USD 800bn with the aim of limiting the extent of the economic slowdown. On Wednesday, the People.s Bank of China cut interest rates substantially and the European Commission presented its plan to stimulate the European economy. Pulling in the other direction were some horrible data, including the University of Michigan confidence indicator, Chicago PMI and the German Ifo index, which all surprised negatively. Market focus was naturally directed towards the ambitious measures announced, especially from the Fed: Equity prices corrected from the low point reached in week 47, the VIX index fell below 55, and the price of oil rose above USD 50 a barrel. At the same time, there was a general strengthening of currencies that normally appreciate when risk appetite increases (AUD, NZD and SEK), while counter cyclical currencies such as CHF and JPY (and USD) weakened.


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Another Bailout Sunday

Steve Chan, Economist, TD Bank Financial Group

Citigroup was rightly judged too big to fail. This time around though, authorities got ahead of the curve and intervened before a potential imminent collapse of a financial behemoth. The U.S. Treasury will inject $20B worth of capital into Citigroup via an extension of the TARP program, in exchange for $7B in preferred shares at 8% yield. Furthermore, the Treasury, Federal Reserve (Fed), and FDIC will guarantee $306B worth of bad assets with Citigroup on the hook for an initial $29B of losses and the trio of regulators on the hook for $9 out of every $10 in losses above-and-beyond that. The bottom line for markets here is that through improvisation and/or nimbleness (take your pick), authorities are making good on their word to do whatever needs to be done to shore up financial markets. In the process, they are helping to stem the massive erosion of wealth in equity markets. North American equity markets mostly shrugged off bad economic data. As of midday Friday, the S&P500 and S&P/TSX were up respectively 10.5% and 6.5% from their previous Friday close.


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UK Public Sector Debt Set to Rise Sharply

Trevor Williams, Chief Economist at Lloyds TSB Financial Markets

This is undoubtedly the toughest Pre-Budget Report (PBR) that labour has had to deliver since it took office in 1997. For a start, this is the first recession the government has experienced – although one was only just avoided in 2002, helped by increased public spending. But this time, the fiscal position is much less favourable, with a budget deficit of 3% of gdp compared with a surplus of 1½% of gdp in 2000 before the sharp economic slowdown began in 2001. The UK and world economy face huge challenges, the likes of which the financial markets in particular have not seen since the 1930s. In normal circumstances, slower economic growth should lead to slower growth in tax receipts and faster growth in government spending, resulting in increased government borrowing, but with the current financial crisis the fiscal deficit will be even larger. This means that the deficit will worsen due to the deteriorating economic environment - and the announcement of additional measures to prevent the slowdown from being even more severe - and measures already announced to help offset the threat of the credit crisis. Hence, we focus on what the Treasury’s forecasts will be given the change in the economic environment and the additional fiscal measures that are likely to be announced.


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