Complex Made Simple

What QEIII in the US means for the Middle East

The US might have lost its triple A credit rating at the start of August, but its central bank is still the most watched in the world. And developments in recent days suggest that the Federal Reserve might be about to embark on another "journey to the unknown" that may deeply impact the global economy.

By Kathleen Brooks, Research Director

Forex.com

It is trying to boost the flagging US economic recovery with another round of quantitative easing, possibly as early as next month. Quantitative easing or QE is essentially when the central bank buys government debt to try and bring more money into an economy and boost spending and investment. But this is not quite a journey into the unknown – if there is more QE it would be the third attempt.

You could argue that QE hasn’t worked – the US economy fell into a lull last summer before QE2, now it has fallen into another lull a year later. But if it hasn’t worked, why keep trying it? This is the question that economists will answer for years and years. The short answer is that the type of recession suffered by the US and most of the Western world is particularly difficult to recover from.

Basically the US, UK and parts of the Eurozone went on a debt-filled spending binge for most of the last decade and now the credit card bill has come due. This is afflicting individuals and countries alike, as the global economy becomes less tolerant of weak public finances and high debt levels. If you dramatically reduce spending (both private and public) then economic growth suffers, which is what the US is currently experiencing.

There is a stark choice for central bankers: either let the economies work their way out of their debt spirals and allow living standards to suffer or step-in and try and try to ease some of the pain. Unsurprisingly, the US central bank has chosen the latter option, and hence the prospect of QEIII is once again back on the table.

Effect of Quantitative Easing on US Dollar

But while the drivers of QE are domestic, the effects are most definitely global. QE2, which lasted from November 2010 to June 2011, was the chief driver of a major decline in the dollar and a rally in stocks and commodities that fuelled food and energy price inflation around the world. Some wonder how can an economy as hobbled as the US have so much power, but it’s worth remembering that the US still has the largest economy in the world and it’s people are still some of the richest on the planet. But most importantly for the Middle East, QE can have a dramatic effect on the dollar.

The Middle East is reliant on the US in two ways: 1, demand for its oil and 2, links or “pegs” between the dollar and some regional currencies. So when the dollar moves the Middle East needs to take notice.

The first question to ask is: what will happen to the dollar in the event of QE3. The dollar has fallen more than 11% over the past 12 months and a lot of this is put down to QE2. Since it is already close to record lows, can the dollar really fall much more? We tend to think not, and instead would look for a slow grind lower in the dollar rather than an outright collapse in the greenback.

But even a slow decline in the dollar’s value will have two important impacts on the Middle East. Since QE3 would be a hindrance to dollar appreciation and commodities are priced in dollars, energy and food prices would likely remain elevated for some time. This will boost profits coming into oil producers’ coffers, however that comes with its own problems including how to invest all of these dollars if the trajectory for the greenback is lower. Profits will need to be protected so money managers in the region have their work cut out for them.

A more worrying problem in the current social and political environment is that if the dollar continues to decline and commodity prices continue to rise then inflation will remain elevated. This was one of the leading causes of the Arab Spring protests, and political and social tensions remain high.

Unfortunately, this problem can’t be solved easily – central banks across the Middle East will need to take tough action to ensure price pressure is stamped out. This may include reigning in lending or hiking interest rates. However, the social problems will only be overcome if governments follow the central banks into action and reform social programmes, especially jobs programmes in the coming months and years.

The Middle East needs to embark on far-reaching economic and social reform to ensure it can reach its potential. The prospect of QE3 makes the need for brave reform even greater.