The Federal Reserve is buying $85 billion of Treasury and mortgage bonds monthly for an indefinite period (QE Infinity) and some members of the Federal Open Market Committee (FOMC) started debating a change to the size of the monthly purchases. They refer to this as "tapering" down the program. Janet Yellen, the Fed's vice-chair, added to the calls for tapering in a speech yesterday. However, advocates of tapering are not calling for an end of the bond buying program now. In fact, the tapering debate may mean that we have QE for longer. In this article I will explore the tapering debate and the connection between QE and the S&P 500.
Quantitative Easing And The S&P 500
The FOMC's previous Quantitative Easing programs, which increased the size of its balance sheet through bond purchases, have been correlated to strong performance for the S&P 500.
SPY data by YCharts
This trend has continued with the current QE, which started late last year.
QE Infinity Needs Tweaking
The FOMC's QE Infinity represented a big change from prior programs. Unlike prior programs that specified the size of the program and the end date, QE Infinity is open-ended.
The problem with QE Infinity as it was originally intended - $85 billion of monthly purchases indefinitely - was the lack of flexibility. The FOMC could do all or nothing and the calls for tapering are meant to tweak this.
The statement following the March 20, 2013 FOMC meeting stated the following about end-point of QE Infinity:
"The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives." (Source: FOMC, bold added by the author)
The comment about the size, pace and composition of asset purchases seems to pave the way for the FOMC to reduce the size of QE Infinity down from $85 billion.
Janet Yellen's Speech
A number of speeches by FOMC members since the last meeting have been about the issue of tapering. Janet Yellen's speech yesterday furthered that debate.
Interestingly, Yellen argues that the FOMC should be open to tapering the $85 billion of bond purchases in the context of enhancing the FOMC's communication about its intentions for monetary policy. Yellen believes that communication is an important tool in monetary policy. She stated:
"In its most recent statement, the FOMC also indicated that the pace and composition of the purchases may be adjusted based on the likely efficacy and costs of such purchases, as well as the extent of progress toward the Federal Reserve's economic objectives. In my view, adjusting the pace of asset purchases in response to the evolution of the outlook for the labor market will provide the public with information regarding the Committee's intentions and should reduce the risk of misunderstanding and market disruption as the conclusion of the program draws closer." (Source: FOMC, bold added by author)
It is important to note that Yellen, and some other advocates of tapering, are not suggesting that the Fed immediately cut down the $85 billion of bond purchases. Rather, they want it to be a tool that they can use in the future.
Furthermore, Yellen advocates tapering because she wants to use the amount of monthly bond purchases to send a message to the public about the FOMC's outlook. She is not advocating for smaller asset purchases because she is afraid of the size of the Fed's balance sheet or because she doesn't think asset purchases are successful policy.
QE Infinity Has a Long Way To Go
My guess is that the FOMC will continue with QE Infinity until around January 2014 when Ben Bernanke's term as chairman of the Fed ends. I expect that the Fed's balance sheet will increase to ~$4 trillion (basically $85 billion monthly until January 2014).
In fact, the concept of tapering could mean that we have QE for a longer period, even if the amount is smaller.
It seems from Yellen's comments that she believes that the effectiveness of a QE program depends, in part, on its size. Yellen said in the speech today:
"Current research suggests that the effects of asset purchases today depend on expectations of the total value of securities the FOMC intends to buy and on expectations of how long the FOMC intends to hold those securities."
The Fed will likely keep QE going for a long period and increase the size of its balance sheet substantially because it is still far away from achieving its targets of maximum employment and stable prices.
The FOMC currently defines maximum employment as an unemployment rate in the 5.2-6.0% range and inflation in the 2% range. There is a lot more work to do until unemployment goes down and inflation goes up to reach those targets.
For more about the FOMC's targets and projections, please see my article "Watching Key Charts For Quantitative Easing Clues And A Big Move In Bonds."
QE Infinity & S&P 500
The debate about tapering does not mean that the FOMC is going to stop QE in the short term or significantly reduce the size of its monthly asset purchases. The FOMC has a long way to go until it reaches its targets and will likely expand its balance sheet by a significant amount before it is done.
The Fed could easily expand its balance sheet to ~$4 trillion. The graph at the beginning of the article showed the correlation between the S&P 500 and size of the Fed's balance sheet. Therefore, the growth of the Fed's balance sheet will continue to be a positive catalyst for the S&P 500 for the next few months.
It is important to note that in previous QE programs, the S&P 500 peaked before the end of the program. However, if QE Infinity still has a lot further to go, I don't think that the S&P 500 will peak now. There are other factors that impact the S&P 500 and for more about that please see my article "S&P 500's Summer Slumps And Why This Summer Could Be Different."
Janet Yellen added to the chorus calling for tapering. However, she advocated for tapering in the context of enhanced communications policy and not because she believes that the FOMC needs to end its bond buying in the short term. The Fed may adopt tapering, but could continue to buy bonds and increase the size of its balance sheet for a long time. My projection is that the balance sheet will grow to ~$4 trillion. Considering the correlation between the growth in the Fed's balance sheet and the S&P 500, it may be poised for further gains in the coming months.
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