All Hail QE (Quantitative Easing)

Economic Pulse
March 13, 2015
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Quantitative Easing—the process by which a central bank stimulates an economy via bond purchases that subsequently flood commercial banks with excess reserves—has been become the norm for developed nations around the globe. It has been implemented by the Bank of Japan (March 2001 - March 2006, and in subsequent years), by the Federal Reserve (November 2008 - October 2014), the Bank of England (March 2009 - November 2009, October 2011, February and July 2012) and most recently, by the European Central Bank. Many critics feared that these programs—seen by some as money-printing schemes— would create inflation. Instead the opposite result has occurred. In the U.S., bond purchases by the Fed have 1) dramatically decreased interest rates, 2) raised the monetary base, 3) and left core inflation far from the central bank’s target (Chart 1).

Chart 1: US Monetary Base, Treasury Yields and Core Inflation

US Monetary Base, Treasury Yields and Core Inflation

Rather than creating inflation in goods and services, Quantitative Easing has raised asset prices, particularly for those assets such as equities and real estate that can be financed with low-cost, borrowed capital. As aggressive central bank bond-buying has pushed interest rates to record lows, cap rates have declined in tandem, led by investors seeking alternative (albeit riskier and higher-yielding) places to park capital. Inflows into commercial real estate have accelerated over the past several years—particularly from foreign investors (Chart 2).

Chart 2: Cross-Border Flows into the U.S. and Average U.S. Cap Rates

Cross-Border Flows into the U.S. and Average U.S. Cap Rates

With the U.S. dollar still viewed as the world’s reserve currency, flows into U.S. real estate are apt to continue throughout the balance of the year. The high income component (and potential for capital appreciation) of real estate provides an appealing alternative for pension funds, sovereign wealth funds, and insurance companies, whose returns are hampered by low (and negative) interest rates in much of the developed world. Moreover, many of these funds are underinvested in real estate; Norges Bank Investment Management, the fund manager for Norway’s $886B state pension fund, had a 1.3% allocation to real estate as of Q3 2014, below its 5% maximum allocation, for example. Given the daily trading volume and size of the U.S. bond market (Table 1), particularly relative to U.S. real estate annual flows, we maintain our view that U.S. real estate assets will perform well into 2015, even though returns may be hampered by the prospect of a Fed that normalizes policy rates in H2 2015.

Table 1: US Bond Market Statistics, 2014

US Bond Market Statistics, 2014