Wednesday, April 22, 2009

Exiting Quantitative Easing

Currently there are many investors who wonder how central banks will eventually exit from their quantitative easing policies. One of the main functions of quantitative easing currently is, of course, to help governments fund their ever-increasing debt burdens.

What concerns investors is what will happen when economies recover (and they will eventually). In order to reverse quantitative easing, central banks will need to shrink their balance sheets by reselling bonds. Most likely at a time of economic recovery, commerical banks will follow suit. Yields will leap higher in the ensuing bond glut and so too will interest rates.

In order to compensate for higher government borrowing costs, governments will need to slash spending. This is what Japan did in 2006. Economies will then face a double tightening - from higher interest rates and from lower government spending. That raises the likelihood of a double-dip recession.

Unless, of course, central banks do not tighten. But then inflation would set in. This is the most likely scenario - governments will not allow their central banks to tighten and a wave of high inflation will ensue. This is especially true in the United States.

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