Quantitative Easing: QE 4ever?

QE (2)We are all in the midst of one of the biggest global financial experiments ever conducted: Quantitative Easing. Since the world financial crisis in late 2008, the Fed and other central banks have employed this technique in an effort to stimulate the world economy. QE has certainly has had an impact. It has reduced home mortgage rates to all-time lows and helped push the stock markets to all-time highs. Yet, QE is not an elixir. QE can’t cure all the ills of a moribund world economy. Furthermore, QE could ultimately cause major damage to the U.S. and world economy.

Last week, a good friend and client suggested that an update on QE might be appropriate for our readers. Good idea DD; thanks for the suggestion.

Quantitative Easing is an unconventional monetary policy used by central banks to stimulate the economy when conventional monetary policy isn’t working. Historically, the Fed has principally stimulated the economy by lowering short-term (fed funds) rates and cooled down the economy by raising short-term rates. However, by late 2008, the Fed funds rate was as low as it could go-effectively at zero. The Fed needed another tool. QE, last used in the U.S. from 1932-1936, got the call.

QE has the same effect as printing money. The central bank buys treasury and agency bonds from commercial banks and other private institutions (using electronic transfers), thereby creating money and liquidity. The purchases raise bond prices and reduce their yields, thereby reducing long-term interest rates. Interest rates on 10 yr. U.S. Treasuries have fallen from roughly 3% to 2% since QE started. Lower treasury rates mean lower home mortgage rates, which has certainly helped the housing industry get back on its feet.

Many investors, uncomfortable with lower returns on fixed income, started loading up on stocks and riskier debt. Since the start of QE, there has been an 85% direct correlation between the amounts of money added to QE and the rise in the stock markets. During 1Q2013, the move to riskier assets intensified. The result -stocks hitting all-time highs. Furthermore, increasing stock values have been shown to affect both consumption and investment decisions, which helps the economy as well.

Other developed countries have also adopted QE to stimulate their economies. The UK started in 2009. The European Union started in 2011. And Japan, which used QE in 2001-2006, started a new round of QE last year. In total, about $10 trillion has been invested by central banks world-wide in QE programs.

There are two major concerns with QE. First, many believe that QE will ultimately cause inflation-perhaps hyperinflation. With the money supply expanding faster than the real economy, one would expect inflation to occur. This hasn’t happened yet. Fortunately, the U.S. dollar continues to be the world’s reserve currency. Hence, events in Cyprus and other parts of Europe cause investors to dump the euro for dollars. Certainly if China and/or Saudi Arabia would ever drop the dollar or dump U.S. Treasuries, we could certainly see a run on the dollar and perhaps hyperinflation. However, that scenario, if it does occur, is likely years or decades away.

The second concern of QE is the impact when it starts to unwind. At their FOMC meeting in March, the Fed signaled that it would keep its ultra-easy money policy for now. They will continue this at least as long as the unemployment rate is above 6 ½%. As it approaches this level, it is expected the Fed will taper off QE. However, Chairman Bernanke made it clear that the Fed would discontinue QE long before it would raise the fed-funds rate. And it promised to keep the fed-funds rate at current levels until 2015.

So, the net effect is that once there is a substantial improvement in the economy, QE will stop. This will likely result in higher interest rates and higher inflation- both of which could slow economic growth. As a result, some are calling for the Fed to start unwinding QE now. With the unrest in Europe and around the world currently, perhaps the impact of unwinding of QE now would be less damaging to the U.S. economy than it will be in the future.

Rest assured, DWM is following QE very carefully. This experiment has already had a huge impact on the U.S. and world economy and undoubtedly will for years to come.