Quantitative Easing and Tapering are overrated

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A quick review of Quantitative Easing

November 2008:  Federal Reserve begins buying $600 billion worth of mortgage-backed securities on the open market to stimulate the economy.

November 2010: Fed begins buying $600 billion of Treasury securities, a process that became known as “QE2.”

September 2012: Fed announces plans to purchase $40 billion of mortgage-backed securities per month on the open market, a process that became known as “QE3” (or sometimes “QE-Infinity” because it has no definite end).

December 2012: Fed increases its purchases from $40 billion to $85 billion per month by adding $45 billion per month of US Treasury purchases.

June 2013: Ben Bernanke mentions “tapering” of the Fed’s QE program contingent upon positive economic data; he indicates that the Fed could scale back bond purchases at some point and suggests that the program could wrap up my mid-2014. Bernanke also suggested the Fed may start raising rates at some much later date and that the Fed’s target rates of 2% for inflation and 6.5% for unemployment would be key measures in this latter decision.

The Myth of QE

Myth: Quantitative easing (QE) is responsible for most of the post-recession growth in the stock market and the US economy since 2008. By introducing trillions of new dollars into the economy, the Federal Reserve is “printing” money, and once this artificial injection of capital (aka “life support”) stops, the US economy will be seriously crippled.

While many analysts, journalists and others in the investment world who are paid to have an opinion would certainly agree with the above statement, we strongly disagree with it and would like to debunk this myth. Because the Fed is buying bonds on the open market, the sellers of these bonds (the parties who receive cash from the sale) are mostly banks and other large financial institutions, in large part because of the sheer volume involved. Thus, the first question that needs answering is: Where is all this cash going?

A bank can do one of three things with cash: (1) make loans, (2) buy securities, (3) park the money at the Federal Reserve (in the form of “excess reserves”) where it earns 0.25% annual interest. Option 2, using the cash to buy securities, seems highly unlikely as the cash just received was from selling securities, leaving options #1 and #3 as possibilities.

Back when QE first started, the Fed may have hoped that banks would use the cash received from selling their bonds towards lending, but this didn’t turn out as planned. The graph below, which shows the amounts of different types of loans made by large US commercial banks, illustrates that lending has barely increased since the Great Recession (shaded in gray) ended. Thus, it looks as if option #1 wasn’t utilized, either, suggesting that most of the cash generated from selling bonds to the Fed went straight back to the Federal Reserve in the form of “excess banking reserves.”

The following graph shows the growth of various types of assets on the Fed’s balance sheet—securities held (Treasuries, mortgage-backed and agency) and bank reserves (the purple line). As you can see, bank reserves shot up immediately after QE1 was launched, and their growth has continued right up through today.

Why is the Fed still doing quantitative easing if the money isn’t going into the economy?

We can think of a few reasons, each of which may be having some effect. First, by holding bonds on its balance sheet, the Fed is reducing the federal deficit: the Federal Reserve receives interest payments on these bonds from the US Treasury, and then sends the interest right back to the Treasury each quarter. Second, banks’ balance sheets are healthier because the additional excess reserves improve their capital ratios as required by regulators.

There’s also the supply-demand argument that says that the additional demand for mortgage-backed and Treasury securities coming from the Fed’s regular purchases has reduced long-term interest rates. This may have been true for a while, but the rapid spike in rates that occurred right after Bernanke whispered the word “taper” indicates that changes in investor demand can rapidly overwhelm $85 billion a month in Fed purchases.

Perhaps the most important justification for QE is psychological. With the support of the Federal Reserve, investors seem to have greater faith in the economy and the stock market, as evidenced by the market’s positive reactions over the past few years to news of additional or continued bond buying and the opposite response to announcements that QE will be scaled back. These knee-jerk reactions to changes in QE should gradually abate as it becomes clear to investors that neither the economy nor the stock market required resuscitation from the Federal Reserve. They will eventually understand (as do you after reading this) that the math is simply not there to support the assertion that QE has been responsible for much of the country’s post-recession growth. That growth came, and will continue to come, from improving individual and corporate balance sheets, increasing consumer, business and investor confidence, and of course, the relentless march of technology.

We at KCS don’t fear the end of QE, and neither should you.

Wishing everyone a happy (and profitable) 2014!

       Adam

Dr. Ken Waltzer MD, MPH, AIF®, CFA, CFP®
Founder and President – Kenfield Capital Strategies (KCS)

Adam Bragman
Director of Business Development – Kenfield Capital Strategies (KCS)

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