bye bye, QE

Yesterday the Fed made public its current assessment of the US economy, something it does on a regular basis.  It its press release, the agency said it had “decided to conclude its asset purchase program this month.”  In other words, the third round of quantitative easing (QE) by the Fed since the economy turned down in 2008 will end tomorrow.

what QE is

The Fed’s job is to foster maximum sustainable economic growth and employment, without creating inflation.  Its usual tool is short-term interest rates: it raises them when the economy is starting to overheat and lowers them during a slowdown.

The recession that began six years ago was so bad, however, that even lowering short rates to zero wasn’t enough to put the economy back on an even keel.  So the Fed also began to add extra stimulus,  pushing down long-term interest rates as well by buying Treasury bonds and government agency debt (especially mortgage-related).  QE is the long-term bond purchasing program.

The weird name apparently comes from a UK economist who lives near the shipyards where the Queen Elizabeth was built and likes the initials.

what its end means

The Fed thinks the economy is strong enough to be weaned off QE.  The labor market is improving; the economy is stronger; inflation is right around the Fed’s 2% target.

The next step, sometime next year (April?, June?), will be to start raising short-term interest rates back to normal.

The move up to normalcy is important for two reasons:

–at some point–not any time soon, but at some point–very strong money stimulus becomes bad for the economy.  It doesn’t boost output any more and starts to create runaway inflation.

–the Fed would like to be in a position to respond to a new emergency by lowering rates.  At present, other than more QE, whose effectiveness is a matter of debate, the Fed has no tools.

how high?  how fast?

Members of the Fed’s Open Market Committee periodically publish their views on, among other things, the course of short-term interest rates.  Their median projection for the Fed Funds rate is:

2014      0 – 1/4%

2015     1 1/4% – 1 1/2%

2016     2 3/4% – 3.0%

2017     3 5/8% – 3 7/8%.

FOMC members think that the end-2017 rate of around 3.75% is normal.

So: the process of normalization will take three years, and will have short rates rising by close to 400 basis points.

how right?

The current target normal Fed Funds rate of 3.75% is 50 basis points lower than when the Fed began publishing projections like this a while ago.

My sense is that financial markets think the figure is still too high.  If we were to assume, for example, that inflation would run at 2% and a short-term lender should get a 1% real annual return for the use of his money, then short rates should be at 3%, not 3.75%.

what should an equity investor think?

We know for sure only that interest rates will be going up next year.  That can’t enhance short-term economic activity.

In the past, in periods of rising interest rates stocks have gone sideways and bonds have gone down.  Maybe things won’t play out the same way this time, but past experience suggests it will.

The period of greatest uncertainty about rates will likely come before the process begins.

Positive economic energy in the US can play out either through higher stock prices or currency appreciation, or some combination of the two.  We’ve already had recent substantial appreciation of the dollar vs. the euro.  If the dollar continues to rise, it will be important not to have exposure to euro earners.  Users of euro-denominated inputs will benefit, though.

Because a higher dollar acts somewhat like a rise in interest rates, continuing dollar strength seems to me to suggest slower Fed action.


More about this when I write about strategy for 2015.




2 responses

  1. Great post – I hadn’t even heard the Fed was planning to stop QE and raise rates. Usually they’re more coy about this. They would also be more political – odd that they would announce they were raising rates right before an election.

    • Thanks for your comment. You’re right that the Fed has traditionally been secretive, on the idea–which never made much sense to me–that only unanticipated changes in policy had any effect. Ben Bernanke changed that, and began a practice, which Janet Yellen has continued, of much greater disclosure of the Fed’s thoughts and plans. Almost everything can be found on the Fed’s website.

      The Fed has been writing that it won’t raise rates “for a considerable time” after the end of its long-term bond buying. In response to a reporter shortly after being confirmed as Fed chair, Yellen said that meant six months.

      Many commentators believe (me, too) that the Fed will raise rates in .25% increments, each time right after a regularly-scheduled FOMC meeting. So they figure that rates will go up at the last five/six meetings of next year.

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