In its press release of October 29, 2014, the Federal Reserve said that it was seeing sufficient strength in the economy to warrant the end of its “asset purchase program,” which is otherwise known as Quantitative Easing. Specifically, the press release said:
The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month.
www.federalreserve.gov – Monetary Policy Releases – Federal Reserve Issues FOMC statement.
This will be a rather long post. Here’s the short version. You can click the More button below the paragraph to get the full version.
The Federal Reserve has completed its program of security purchases, in which it pushed interest rates lower. With the program ended, there will be one less force keeping a lid on interest rates, and rates could head higher. Higher rates have historically been a drag on the economy and have historically hurt stock prices.
Whether from folks who didn’t know what the phrase meant and/or from folks who wanted to read more, Google Search volume on the phrase “quantitative easing” jumped to the highest level of 2014, as shown in the chart from Google Trends below.
If others are concerned enough to search out the phrase on Google, should you be? Well, it probably depends, but if you want to know what it means and how it might affect you, read on for a non-technical explanation.
Following the announcement, however, stock prices have risen, as shown in the chart below.. That’s not surprising, however, as the market has known for some time that Quantitative Easing would be ending. There are always multiple forces at work in securities markets, and perhaps market participants had already discounted the news, factoring it into security prices.
Chart courtesy of StockCharts.com
From here on, we’ll use QE to refer to quantitative easing.
There’s a saying that goes like, “to a man with a hammer, everything looks like a nail.” The Federal Reserve is like that man. It’s only tool is something called monetary policy, and while it can include a hammer like raising or lowering the Reserve Requirement Ratio for banks (don’t ask), the hammer it usually pulls out of its tool box is raising and lowering interest rates. Oh, and to carry this metaphor just a bit further, these hammers are big and blunt; these aren’t jewelers’ hammers. It tries to raise and lower interest rates by trading in the Federal Funds market by way of its Federal Open Markets Committee, otherwise known as the FOMC, disparagingly known as the open mouth committee. The rate it tries to manipulate is the Federal Funds Rate.
Put very simplified, when the Federal Reserve wishes to stimulate the economy, it tries to push interest rates lower; when it wishes to slow down the economy, it tries to push interest rates higher. You can see a brief explanation of how this effects the economy and other aspects at my recent blog post, Why Should You Care if Interest Rates Go Up?
Pictured below is a chart of the Effective Federal Funds Rate (FFTR).
Notice what happened after the great recession of 2008/2009. The FFTR had been hammered—pun intended—all the way to zero—or as close to zero as it could get–and it has stayed there ever since. Notice that this happened pretty quickly—or, as my dad would say, DI-rectly. In spite of this heavy dose of stimulus, the economy remained weaker than the Fed was comfortable with. There are lots of reasons why the stimulus didn’t produce the desired results, but that isn’t the focus here. Suffice it to say, more stimulus was needed. Time to look for another hammer.
The hammer the Fed turned to was quantitative easing, the term for used for the process to drive interest rates lower when the zero bound of short-term rates is reached. In quantitative easing, the Fed purchases assets, bonds, in the current case.
The reason that QE is referred to as money printing—especially by those not in favor of the process—is that it seems to produce money from nothing. While there is no printing of currency involved, the Federal Reserve really does sort of create money. The way it does this is by buying the target securities from its network of 18 Primary Dealers, some of the world’s largest banks. When it buys them, it “creates” the money by recording a credit to the bank’s account with the Fed. This buying pushes up the prices of the securities it bought, say 10-year Treasury notes. It’s not like the higher prices lower interest rates; but higher prices equal lower rates; it’s not cause and effect; it just is.
In the chart below, you can see the three incarnations of Quantitative Easing, periods when the Federal Reserve was buying securities.
For the past several months, the Federal Reserve has been reducing its purchases of securities. This process has become known as “tapering,” as in, the Federal Reserve is tapering down its purchases. The last tapering was down to zero, and, thus, QE has ended.
The reason the Federal Reserve ended QE was because it felt that the economy had developed a solid enough footing to not require any more monetary policy stimulus. Keep in mind that, while interest rates remain ultra low, that the Federal Reserve is not adding stimulus. Low rates, themselves, should serve as a stimulus to the economy.
What will be different now is that the Federal Reserve will not be acting to keep a lid on interest rates. This may keep markets on edge. (The aforementioned blog post points out some of the untoward effects of higher interest rates.) In addition, in the cycle of traditional (i.e. non-QE) short term interest rates manipulation, the process has historically been raise rates>rates stay high>lower rates>rates stay low>…raise rates. So the next movement for short term rates, if the economy continues to improve, is expected to be upward.
Normally, this upward movement is the result of the Fed acting to fight rising inflation. While that will be a concern, the Fed also needs to get interest rates back to some normal level, perhaps between 2-3%, and we believe it will likely raise rates some time just to get back to an interest rate level from which it can, eventually cut rates.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.