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Quantitative Easing: The Good and the Bad

Quantitative Easing: The Good and the Bad

In the midst of the financial market meltdown in late 2008, the Federal Reserve’s main policy tool, the federal funds interest rate, was in danger of reaching its lower limit of 0 percent.  By November of 2008, the federal funds rate – the overnight interest rate at which financial institutions loan money held at the Federal Reserve to each other – had been lowered 6 times already that year and stood at 1 percent (100 basis points).[i]  By lowering the federal funds rate through the purchase of short term government bonds (increased demand for bonds drives up their prices and simultaneously lowers their yields) the Fed hoped to generate an increase in consumer spending and business investment.  Without this mechanism, the Fed needed to look towards non-traditional instruments to attempt to jumpstart the economy.  Taking a page out of the Japanese central bank’s playbook, the Fed announced that it would purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt – a process known as quantitative easing.[ii]  As the recession continued and stock markets continued to decline into March of 2009, the Fed announced that an additional $750 billion in agency MBS and agency debt and $300 billion in Treasury securities would be purchased.   

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One thing apparent from both the interest rate adjustments and QE decisions in 2008-09 was how closely the Federal Reserve watched the movements of the stock market.  On Martin Luther King Day in 2008, stock markets around the world plunged.  The Japanese stock market dropped 5.7 percent, the Australian stock market fell 7.1 percent and the Shanghai market lost 7.2 percent.[iv]  What caused this drop?  At the time, nobody was quite sure but many believed that investors were panicking as the global economy cooled.  Since the U.S. markets were closed for the holiday, the U.S. stock market did not crater that day, but futures were down substantially.  In response to the sharp decline in global financial markets, the Federal Reserve held an emergency meeting on that Monday and decided to lower the federal funds rate by 75 basis points (0.75 percent).  As a result, the markets did not open Tuesday in the hole that many had expected prior to the announcement.  A few weeks later the real reason for the drop in the markets was revealed.  At Societe Generale – one of France’s largest banks - a rogue trade, Jerome Kerviel, had accumulated approximately 50 billion euros in unauthorized positions.[v]  In order to unwind these trades, Societe Generale had to sell securities in many markets throughout the world.  These sell orders overwhelmed buy orders, and pushed the prices of many securities down.  In the end, Societe Generale booked a trading loss of 4.9 billion euros on Kerviel’s positions.  Consequently, the Fed had lowered its main interest rate by 0.75 percent because a French bank was trying to unwind positions in various stocks.  Historically, the Fed acted with a long term outlook because it believed that the effects of their actions would not be seen for at least 6 months.  In a paper written by Bryon Higgins of the Kansas City Federal Reserve in 1982, Higgins explained this very dilemma.

Federal Reserve actions affect monetary growth with a lag.  As a result, attempting to achieve precise short-run control over monetary growth may be inadvisable.  Policy actions necessary to achieve precise short-run monetary control could set in motion forces that would require offsetting policy actions to keep monetary growth on track.  Thus, the Federal Reserve must take account of the future as well as the immediate effects of policy actions in order to avoid whipsawing the economy and interest rates.[vi]

By focusing on the stock market, the Federal Reserve hopes to increase consumer spending through the wealth effect.  The wealth effect is the theory that when the value of stock portfolios rise as the stock market increases, investors feel more at ease and confident in their wealth, and as a result they spend more.  “If people feel that their financial situation is better because their 401(k) looks better or for whatever reason — their house is worth more — they’re more willing to go out and spend,” Chairman Ben Bernanke told reporters after the most recent decision for QE3. “That’s going to provide the demand that firms need in order to be willing to hire and to invest.”[vii]  However, according to a December 2010 paper the European Central Bank estimates that a $1 increase in stocks increases a consumer’s marginal propensity to consume by 6 cents – less than the estimated housing wealth effect of 9 cents for each $1 increase in housing prices.[viii]  Therefore, the foundation for further economic and stock market improvements could lie with the fortunes of the housing market. 

With the Fed’s latest announcement of embarking on a third round of quantitative easing in which it will buy $40 billion of Mortgage Backed Securities each month until the Federal Open Market Committee determines that the economy is on better footing.  Yet, in a poll of 58 economists, 52 of the 58 did not lower their forecasts for the unemployment rate in 2013 or 2014 following the Fed’s QE3 announcement.[ix]  What direct effect could quantitative easing have on an individual?  Matthew Heimer contemplated this in an article on MarketWatch.

Couple X is retiring. They’ve decided to split a $600,000 portfolio into three equal piles and invest it on in 10-year Treasurys (sic), 5-year CDs and a mix of investment-grade corporate bonds that yields the average for that sector. And because they’re a hypothetical couple who live in my head, they’re making all these investments on the same day. If they’d retired five years ago today—before our most recent recession kicked in—they’d have nailed down annual yields 4.81% a year on the Treasurys (sic), roughly 5% on the CDs and roughly 6% on the investment-grade bonds, according to data from the Treasury Department and the BondsOnline Group. Annual pre-tax income from their portfolio: $31,620, not a bad supplement to the monthly Social Security checks. If they’d retired today, based on yesterday’s closing prices they’d be earning 1.83% on their Treasurys (sic), 1.37% on the CDs, and 2.92% on the corporate portfolio. Now we’re talking annual income of $12,240—less than 40% of what they might have earned with different timing.[x]

The consequence of these lower interest rates – and subsequently lower income distributions – is that investors are being forced into considering taking increased risks in order to generate the returns that they cannot obtain from Treasuries, CDs or investment grade corporate bonds.  With inflation running at a higher clip in August than what was expected, gold has suddenly jumped to a 6 month high and Treasury yields have become to creep up again as inflation expectations rise.[xi]  Furthermore, QE3 has touched off another round of easing by other central banks, including in Japan, Turkey and South Korea, in order to avoid a large inflow of capital that sets off inflation. 

Another byproduct of Quantitative Easing has been the large amount of U.S. government debt that has been acquired by the Federal Reserve.  The Fed is now the largest holder of U.S. Treasuries with approximately $1.7 trillion held.[xiii]  By purchasing U.S. debt, the Fed has implicitly financed the federal government’s deficit.  Although the lower interest rates for debt are good for the government, it also allows politicians to continue to put off the tough decisions that are needed to address the government’s debt problems.  In a similar manner, the governments of Greece, Italy and Spain borrowed at the relatively low interest rates that were offered to euro zone governments.  Their debt continued to increase and the structural issues were not dealt with until higher interest rates forced the problem to the forefront.  Therefore, the U.S. should not view quantitative easing as a panacea.  Although the marginal benefits of the most recent round of monetary easing may be minimal, it allows the U.S. more time to address its fiscal issues. 

*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass.  This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan.  The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. All investments involve the risk of potential investment losses and no strategy can assure a profit. Past performance is not indicative of future results.

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