What will happen to the economy after the Federal Reserve begins to slow down its current quantitative easing? This is a hot topic, especially with Janet Yellen on track to become the next chairperson of the Fed, as well as some rumblings from key Fed officials that suggest support for the program is wavering.
Without making a prediction about when the Fed will taper down its $85 billion monthly purchases of treasury bonds and mortgage-backed securities, let's roll into the impact on the economic forecast when it does come. To do that, I'll explain what quantitative easing has done for the economy, how tapering will impact financial markets, and how tapering will impact the timing of stock market and bond market changes.
Economic Impact of Quantitative Easing. Let's look at some data. Quantitative easing is shown by Federal Reserve Credit. On the above chart, I've made the line thicker where the three rounds of quantitative easing occurred. I show the growth rate of inflation-adjusted gross domestic product in red. GDP growth is bumpy, not smooth, but I think I can see some quantitative easing.
A few quarters after the first round of quantitative easing, QE1, GDP growth surged. That's consistent with Milton Friedman's conclusion that the time lags of monetary policy are long. However, it's pretty common for GDP to surge in the first few quarters after a recession, so maybe it would have happened without quantitative easing.
QE2 began in late 2010 and probably triggered the stronger growth a year later -- long time lags, remember. So far we have seen little impact from QE3, but the time lags are long, so perhaps we are in for stronger growth in 2014 because of the stimulus. But perhaps not. Both QE1 and QE2 pushed up money supply growth dramatically. QE1 doubled the M2 growth rate, and QE2 had an even great impact. Since QE3 started, though, money supply growth rates have gradually declined. This indicates that the stronger bank reserves have simply been held by banks, not lent out to businesses or consumers.
It's also clear that quantitative easing is not the great driving force of the economy. In the interludes, the economy did not plummet. The size of these reserve credit increases is huge by historic standards. It's amazing that they did not send the economy into the stratosphere. If the Fed were to suddenly suspend QE3, I doubt that the real side of the economy -- spending, production and employment -- would show much impact.
Financial Market Impact of Quantitative Easing. Even if the real economy is unaffected by the taper, financial markets may be impacted. Monthly securities purchases of $85 billion sounds big -- but think about the size of the market. In the United States, treasury notes and bonds held by the public total just over $9 trillion. The Fed’s purchases over 12 months come to about 6% of the total amount outstanding. That's less than the growth rate of the debt, so it's not an overwhelming amount. Regarding mortgage-backed securities, the Fed's purchases also come to about 6% annually.
Six percent sounds big enough to push markets around, but remember that financial markets are increasingly global. A purchase in one country has effects that spread around the world -- and are diluted as they spread around the world. Total global debt is equal to about $223 trillion, of which $56 is government debt. The Fed's purchases are definitely small compared to the world debt market.
Why are interest rates so low if not because of QE3? Interest rates reflect inflation expectations plus the real (inflation-adjusted) supply and demand for credit. Inflation expectations are low, about 2% over the next decade. Actual inflation is falling. The global supply and demand for credit is largely driven by overall economic growth. The world is growing, but at a slower pace than previously expected. Weak economic growth here in the United States, in Europe and in Asia explains low demand for credit and thus low interest rates. It's not all about the Fed.
Timing Impacts of the Fed's taper. Last spring's jump in long-term interest rates appears to have been driven by talk of the Fed's taper, but I don't think that's the best way to describe it. Think of it like this: Investors were wondering about interest rates rising. There was a good bit of uncertainty about when rates would rise. Amidst this hemming and hawing, the Fed started communicating that tapering would eventually happen. That triggered the rise in rates, but the rise would not have happened without a basis in fundamentals. That basis is improvement in Europe's economic prospects, and China's not falling into worse problems.
Federal reserve action can shift the timing of changes in long-term interest rate, but the Fed cannot push rates where fundamentals are not dictating that they go. In conclusion, when the Fed eventually announces a taper, interest rates may rise and stocks may sink. A little. For a short time. However, when the Fed decides to taper will be when the economy is strengthening, which is when fundamentals will dictate higher interest rates. It will be hard to tell the chicken from the egg.
Stocks will be a little different. If the only thing that changed were interest rates, we would expect stocks to fall. The present value calculations will be lower due to higher denominators. However, interest rates will not be the only thing to change. The Fed will taper when the real economy shows stronger growth. That is when the stock market should be stronger. The prospects of better growth will offset the rise in interest rates either fully or partially. My best guess -- and with the stock market, guess is all we can do -- is that stronger economic growth will trump the rise in interest rates. I'm not worried about stocks falling just because of the taper.