As QE2 sails off into the horizon, do not mourn its passing

The end of quantitative easing in the United States marks a shift in monetary policy that should remove uncertainty from world markets, writes Tim Fox.

Financial markets face a critical moment in the coming weeks.

The second round of quantitative easing (QE2) is due to come to an end in the US at the end of this month, which means that the Federal Reserve will cease its monthly purchases of US$75 billion (Dh275.47bn) of Treasury bonds that it has been undertaking since November.

Eight months on since QE2 began, the Fed will have bought about $600bn of treasuries, and since the beginning of QE in its entirety the total amount of securities bought will have exceeded $2 trillion.

While a halt to new asset purchases is still a long way from the Fed actually raising interest rates, it still represents an important milestone on the way to the normalisation of US monetary policy, carrying important implications for financial markets and the world economy.

Coming at a time when both the US and global growth appear to be going through a soft patch, this moment is particularly sensitive.

It represents the end of loosening in monetary conditions, as the Fed will effectively stop supplying additional dollar liquidity into the market. The Fed will still reinvest the proceeds of its existing investments, meaning that the size of its balance sheet will remain the same for some months to come. But the driving force behind the purchase of higher yielding assets/currencies by global investors will begin to lose some impetus.

At the very least asset markets are likely to become more volatile in the wake of this change, but arguably heightened risk aversion and uncertainty about the future will ultimately increase the demand for the dollar.

The weakness of equity markets and recovery in the dollar over the past month in part reflects the anticipation of this event. However, the reappearance of soft economic data has complicated proceedings, or at least perceptions, casting doubt in some quarters over whether the Fed will actually bring QE to an end.

However, it is doubtful if the recent data will stay the Fed's hand. Commentary from the central bank's officials, including the Fed chairman Ben Bernanke, has been consistent in signalling that the end of QE remains on schedule for the end of this month.

The data flow has admittedly been softer than many expected, but the Fed is anticipating this to be temporary, with oil prices already softening again, and supply disruptions related to the weather and the Japanese earthquake likely to be only temporary. These effects have also been global in nature and are not unique to the US.

But with inflation edging higher, real interest rates have been falling recently, effectively providing a further monetary stimulus even as the prospect for further QE fades. Despite the recent slowing in economic momentum, the Fed has consistently stated the hurdle for renewing QE is a high one, and the current soft patch is probably not even near the threshold necessary for such a discussion to take place.

On the contrary, some Fed officials have been heard to mention the possibility of raising interest rates as early as the end of this year. This does not seem likely either, but it does seem that the end of QE2 will mark the beginning of a process that will culminate in the ending of zero interest rates, probably some time next year.

The Fed has already outlined a series of sequential steps by which monetary policy normalisation will be conducted. Following the formal ending of QE2, the next stage will be for the Fed to stop reinvesting principal payments, probably a few months later, around the turn of the third and fourth quarters this year.

Thereafter the market will be on the lookout for the removal of the "extended period" reference as a signal that the policy environment is entering a new era. The first technical manifestation of this will be the replacement of the 0 per cent to 0.25 per cent range for the Fed funds rate with an increase in the interest rate on excess reserves to 0.25 per cent.

Once this process is completed, probably early next year, the way will be clear for the Fed to start raising interest rates again, depending on the data. Probably only then will the Fed start to manage down the size of its balance sheet, a process that may take a number of years to complete.

While the passing of QE is understandably being viewed with some caution in many quarters, our sense is that it should be welcomed. QE has dominated the global monetary policy landscape over the past two years, ever since the financial crisis erupted in 2008.

As a result, QE has become something of a crutch to the world economy, and one that many investors and policymakers are fearful of losing.

However, it could be argued that the existence of QE has also hindered decision-making, lowered confidence levels and contributed to a low level of doubt and uncertainty, as well as creating distortions in markets.

Conversely, that this period is coming to an end, with the prospect of monetary policy normalisation on the horizon, it may turn out to be a turning point that defines a new period of greater optimism, with the crisis era further consigned to the past.

Tim Fox is head of research and chief economist at Emirates NBD