Quantitative easing: not without risk...

In his testimony before the Senate Banking Committee several week ago, Fed Chairman Ben Bernanke said as clearly as central bankers ever say anything that the Fed will NOT tighten monetary policy in the near future. He recognized that the Fed’s policy experiments carry risks but he deemed them manageable or worth taking. 

There are three broad risks associated with the Fed’s QE programs. One is the inflation risk, which the Fed is confident it can manage. The Governors believe the Fed has the tools to tighten monetary policy when necessary. In any case, inflation is not a problem now and inflationary expectations are low.

A less obvious risk is to the federal budget. The Fed earns interest on the assets it has purchased. Between 2009 and 2012, the Fed sent the Treasury on the order of US$290 billion, roughly triple its pre-QE remittances. When the Fed implements an “exit strategy” from its QE program, the interest earned and, consequently, the remittances to the Treasury will fall. Mr. Bernanke expects that even after the exit, the Fed’s remittances to the Treasury will be above pre-crisis levels. A recovering economy, a pre-condition of the exit, generates higher tax revenue, which would more than compensate for the decline in Fed remittances.

A third risk is to financial stability. With US interest rates so low and liquidity flooding the system, portfolio managers may “reach for yield” by taking on riskier credits, greater leverage or lengthening their exposure. The extraordinary inflow of portfolio investment directed to Mexico over the last three years exemplifies how low interest rates and ample liquidity in the US can affect other economies. Mr. Bernanke recognizes that investors may pile on risk in the search for higher returns but believes the benefits of stronger growth and job creation in the US justify the risk. 

The cost-benefit analysis for this last risk -- to financial stability -- may be different for the US and the recipients of massive portfolio inflows, like Mexico. Yes, Mexico will benefit from a stronger US economy. But, the vulnerability to the movements of foreign investment in fixed income obligations and equities is much greater for Mexico than for the US. Time will tell...