Views | Why QE2 did not boost markets in 2011

Views | Why QE2 did not boost markets in 2011

Here is a cautionary take at the end of 2011.

Two massive programmes of bond buying worth a combined $2.33 trillion by the US Federal Reserve - aka QE1 and QE2 - were supposed to send inflation skywards as the extra money created by the Fed chased the existing supply of goods. And some of the extra liquidity was also expected to find its way into emerging market equities.

A recent working paper by the Reserve Bank of India (RBI) showed that FII inflows into India actually fell in the months after the announcement of QE2.

There is an obvious reason for this. The world economy weakened after March, with Europe flirting with a potentially devastating sovereign debt crisis. Economic growth has dropped in other parts of the world as well. Weak demand has capped inflation (though not in India) while slowing growth and risk aversion have weighed down on equity prices.

But there is a more specific reason at play as well. Quantitative easing increased the monetary base in the US, but it didn’t increase money supply enough to trigger the capital flows. Much of the money sits on bank balance sheets. It was not released into the real economy. The excess reserves that American commercial banks hold at the Fed increased from $2 billion in August 2008 to $1,513 billion in May 2011.

Western banks are too busy repairing their balance sheets of lend to consumers and companies.