If the financial media is to be believed, global financial markets are focusing an awful lot of attention on how the US Federal Reserve is going to wind down its quantitative easing program, known as QE. What is actually far more important is how it handles interest rates. Given how complicated and novel the whole monetary policy program is in the US, quite understandably it has created a lot of conjecture and confusion. We have recently attended a couple of seminars that examined how the world might react as QE comes to an end and in this blog post we try to explain what all the fuss is about.
What is QE and why do it?
In response to the global financial crisis, the Fed cut its cash rate to 0.25% – a policy that has come to be known as ZIRP (Zero Interest Rate Policy). The Fed told the markets that interest rates would stay at that remarkably low level for a long time. It turned out that was not enough to get the economy going again so the Fed announced it was going to buy large quantities of a variety of both government and private securities (bonds, mortgage backed securities, etc.) with the aim of keeping bond yields lower than they otherwise would have been.
How does that work? When you purchase a bond, what you’re really buying is an income stream from the interest that the bond promises to pay you, which is also known as the yield of the bond. In really simple terms, if the face value of the bond is $100 and you pay $95 for it, then your yield is going to be 5%. Like almost anything, buying lots of bonds will drive the prices up, which means you get a lower interest rate. If you pay $98 for the bond, your yield is going to be only 2%.
Why would they do that? Bond yields are critically important because they determine the cost that people and companies can borrow at, and also act as a yardstick to measure other investments against. Like any stimulatory monetary policy the Fed was hoping to increase economic activity, which in turn would raise employment: the idea being that companies would seize the opportunity to borrow at really low rates and spend it on building factories or buying new machinery.
How does QE work?
Contrary to popular belief, QE is not actually money printing (in fact much of the creation of money is done by banks via what’s called ‘fractional reserve banking’, but that’s another story). What happens is the Fed buys securities from the banks and, of course, gives them money in exchange. The banks ended up sitting on huge amounts of cash, which was available to lend out. However, the appetite for borrowing was pretty low, and the banks got quite strict about who they would lend to, so the money piled up. Instead of lending the cash out, the banks just deposited it back with the Fed, who paid them a small interest rate (that quickly added up to big numbers).
So the biggest beneficiaries of QE were the US banks: whereas in Australia after the GFC the banks were competing fiercely for deposits and offering huge term deposit rates in order to strengthen their capital ratios (remember when you could get 8% for a 12 month TD?), US deposit rates were pitifully small because they were already being given cash by the Fed rather than having to compete for it from depositors. The biggest losers from QE were retirees and people who rely on interest income. Even now, platinum customers of the Bank of America are getting 0.06% on 12 month term deposits, and 0.2% for 10 years! This phenomenon of effectively punishing savers is called financial repression.
The ‘Wealth Effect’
When bank depositors are getting a negative return on their money after tax and inflation, not surprisingly, they start looking elsewhere. It’s one of the indirect ways monetary policy works: it forces investors to buy riskier assets. Initially lots of money went into bonds, but with yields so low and still falling they lost their appeal too. The next place the money went was in to the stock market, especially stocks paying a high dividend yield. Eventually that enthusiasm spread to other sectors and lo and behold the S&P500 has been trading at record levels. What a lot of market commentators keep talking about is that stock prices have gone up a lot faster than earnings, which is entirely attributable to ‘PE expansion’, that is, paying a higher price for the same level of earnings.
The Fed was happy with this outcome because they were hoping that people would feel wealthier on the back of their stock portfolios rising in value and so would spend more money. The idea is that as more and more money gets spent economic activity increases and it ends up benefiting everybody. Unfortunately most studies into this ‘wealth effect’ suggest it’s nowhere near as effective as the Fed might hope.
Has QE worked?
The US economy has undoubtedly turned a big corner and is picking up steam. Does that mean QE worked? Whilst we can’t unscramble the egg to know what everything would look like without QE, some leading international economists argue that it has made very little difference to the real economy. Even the St Louis Fed (one of the twelve regional banks that comprise the US’s Federal Reserve banking system) has published a paper concluding that QE was ineffective in achieving its goals.
Rather, what we’ve seen is the market at work. US households control about US$1.26tn of savings and lots of money moved to areas where it was going to get a better return. In many cases that was offshore which meant people were selling their US$ to buy foreign currencies, driving down the US$ and making life a lot easier for US manufacturers and exporters. The US housing market is slowly recovering from having built far too many homes. The banking system has recapitalized and is strong enough to lend again. Pretty soon the US economy will have regained all the jobs it lost in the GFC.
Where’s the inflation?
When QE first started many people feared that it would cause hyperinflation, like that experienced in 1930’s Germany. Yet here we are after five years of QE and we’re far more worried about deflation. How can that have happened?
The problem in Germany was that money was literally being printed and put into circulation. The more Marks that were out there the less they were worth. With QE the money never actually got into circulation. Money was only made available to the banks, so liquidity wasn’t a problem (and the banks got effectively bailed out), but that money was kept within the banking system.
Where to from here?
If you believe the financial media, markets have been obsessing about the winding back, or tapering, of QE since the former Governor of the Fed, Ben Bernanke, first mentioned it in May last year. As we’ve seen, it is arguable that QE itself hasn’t made much of a difference. What is far more significant is the inevitable eventual raising of the Fed’s cash rate in the US. Exactly when this will happen and by how much and how quickly is preoccupying many an economist, and as they say, when you get five economists in a room you’ll get eight different opinions.
When central banks raise interest rates it’s normally to slow an economy down. Whilst it will be a good thing that the economy is so strong that it needs to be cooled a bit, higher interest rates will mean there is a more genuine alternative to owning shares, so equity markets may well be impacted.
The latest guidance from the Fed is that they will consider a bunch of different indicators when making their minds up about when it’s the right time to raise the cash rate. The trick is, unlike in the past when they named specific unemployment and inflation targets as the potential triggers for change, now they’re not telling us exactly what those indicators are, let alone what level they need to be at. The very fact that the guidance has changed caused stock markets to wobble because it introduced uncertainty. Best guesses, and that’s all they can be, are that rates won’t start rising until the middle of next year.
It’s unlikely the Fed will rush this decision for a few reasons. First, the Fed doesn’t want to spark mayhem in the markets and cause a negative wealth effect. Second, the new head of the Fed, Janet Yellen, is very smart and an avowed dove, meaning she prefers to tread softly and err on the side of being too gentle than too harsh. Third, the government is a big beneficiary of low interest rates. That’s because a low interest rate environment enables debt to be reduced more quickly and fiscal policy to stay tighter. Like most of the developed world right now, the US government faces an enormous challenge in funding entitlement programs like aged pensions and medical benefits. So there is a political incentive to keep rates low for a long time.
It’s kind of a cliché that at any point of time it feels like the investment environment has never been so unclear, and now is no different. However, one thing we can be reasonably sure about is that the tapering of QE is probably not that big a deal. Another thing we can be sure about is that the eventual raising of the US cash rate definitely is. And as usual, what’s a big deal for the US will be a big deal for the rest of the world, including Australia.