The purpose of this article is to analyze and discuss the Federal Reserve System's responses to the "Great Recession" and subsequent recovery. As the Fed winds down its purchases of assets otherwise known as "Quantitative Easing" (QE), we would like to offer a brief discussion of the results of the policies undertaken. We will attempt to answer some questions such as: What is the goal of QE? What has its effect (or lack thereof) been on inflation and why?
Since the Recession ended, real gross domestic product GDP (adjusted for inflation) has been on a steady rise. In that same timeframe, U.S. stock markets, specifically the S&P 500 (NYSEARCA:SPY), Dow (NYSEARCA:DIA), and the NASDAQ (NASDAQ:QQQ) have performed phenomenally well, as can be seen by the ten-year graph of SPY.
SPY over Ten Years:
Questions about whether we are in an asset bubble have continued to pop up, and we will take a look at the Fed's monetary policy and its effects, specifically on inflation.
The Quantitative Easing Program
It is well known that the United States Federal Reserve has been partaking in perhaps the most accommodative policy decisions central banking has ever seen. Quantitative easing is now approaching its 6th year, with QE1 beginning in November of 2008. When QE began, the Fed purchased mortgage backed securities at a rate of $100 billion a month. The purpose of quantitative easing is to inject liquidity into financial markets. By providing cash for assets, the Fed has greatly increased the availability of dollars for banking institutions. Meanwhile, increasing the supply of money decreases the cost of borrowing money which is why we have seen interest rates at historically low levels as the Fed's accommodations have prolonged.
Over the course of 17 months, $1.7 trillion dollars in assets were purchased in the first round of accommodations. In that timeframe, the adjusted monetary base grew from $1,265 billion to $2,076 billion or an increase of 64% from November 2008 to April 2010.
Beginning seven months later, the Fed began another round of easing in November of 2010, this time at a rate of $85 billion each month. This time, however, instead of purchasing mortgage backed securities, the Fed bought up U.S. treasuries. During the seven month program, the monetary base expanded to $2,625 billion, a 26% increase.
Finally, QE3 began more than a year later. Each month purchases of mortgage backed securities and U.S. treasuries rang up to $85 billion.
In addition to the quantitative easing programs, a program known as "Operation Twist" was started in September of 2011 to lower interest rates on long-term bonds. While the Fed purchased long-term securities, it also sold short term bonds to the tune of $400 billion so as not to affect the money supply. "Operation Twist" was given its name based on the desired effect on the yield curve. Essentially, short term interest rates rise with the increasing supply of short-term bonds as the Fed sold them, and long-term rates decline as the Fed continued purchasing treasuries.
As of July 23 the adjusted monetary base stands at now $4,040 billion and rising. However, with the Fed set on winding down its purchases by October of this year, we will examine some of the arguments about the policies implemented by the Federal Open Market Committee and determine possible outcomes of the spike in the monetary base of roughly 400% since QE1 first began.
The Growing Monetary Base:
For all of the increase in the monetary base, though, inflation has not really been a problem for Ms. Yellen, Mr.Bernanke and company -- see below:
Cries about inflation have rung out ever since the Fed first began its accommodation programs in 2008. Basic economic principals suggest that an increase in the money supply should increase prices of goods, all else equal. Clearly though, the rapid increase in the base has not had the dire inflationary effects many originally feared. The reasoning baffles some people to be sure, but the economic principal of money velocity explains why we have not seen rapid inflation in proportion to our growing monetary base. Money velocity is simply the rate at which money is exchanged from one transaction to another as well as how much of the currency is used in a given time period. As we can see below, money velocity has been on a steadily decline since the recession hit.
This is key to measuring inflation in our economy and its nearly relentless downward trend suggests we are still in the low end of the business cycle. This in great part has made the Fed's monetary easing far less inflationary and detrimental than most people fear. However, the question remains: what happens when we do start increasing output at a greater rate and money velocity reverses its trend?
First quarter GDP came in at a contraction of 2.9%, far worse than expected. While many experts blamed adverse weather conditions, skeptics remained convinced that another recession is on the way. After a revision to -2.1% for first quarter GDP growth and the recent report for the second quarter, many of those concerns have subsided; instead, concerns about inflation have rebounded. Most recently, inflation came in at 2.1%, just .1% above the Fed's target rate. This is coupled with initial reports of 4% growth in output along with a .7% rise in labor costs, so overheating in the economy has suddenly become more of a worry.
As labor costs rise, these expenses have to be made up for by companies. The most obvious reaction to rising input costs is increasing the prices of final goods to make up the difference. As labor costs continue to rise, this can be good news for wage earners in the U.S. and the labor market. If those input prices rise too quickly, though, inflation will become a problem, and if wages do not rise at least as fast as inflation, personal income will fall on a real basis, meaning consumers cannot purchase as many goods with his or her paycheck as before.
A steady stream of hints that inflation is increasing faster than desired will cause the Fed to swing its easing in the opposite direction. Officials do not want to make the mistakes of the 1970s when rampant inflation due to overly lax monetary policies left Mr. Volcker, the Fed Chairman, no choice but to hike interest rates and cause a recession.
With money velocity at an all-time low since that time, inflation concerns, while justified, will remain on the back burner. The Fed has continually looked to the labor market for indications that it should rein in its accommodative policy. We do not expect the Fed to change that approach until at least after asset purchases cease in October. By that time, we will have a clearer picture of the U.S. economy's direction in 2014 once revisions for first half GDP and third quarter are released. The Fed has maintained that interest rates will remain historically low for an extended period of time, and this has held true thus far. However, our biggest fear is an unexpected increase in the money velocity, which may result from expectations of rising interest rates. In other words, businesses may start to spend more, making transactions more common, in anticipation of not being able to receive as good a deal tomorrow as they can today. One can expect this possible outcome once the Fed ends QE3 and begins talking about increasing the Federal funds rate. Money velocity could very easily reverse its trend along with inflation.
At this point, it is far too early to call the Fed's easing policies a failure. In fact we contend, as do many experts, that the recession could have been even deeper and this recovery even more prolonged if not for the unique purchasing programs undertaken. Inflation has really been nonexistent by most measures, and the economy has been growing, albeit slowly. And even though we can see rising underemployment and falling labor participation, at least the unemployment rate has come down significantly since 2008-2009. And with rising wages (exemplified by a .7% increase), more working age people will decide to come back to the workforce.
If and when the economy begins to overheat again, hopefully the Fed will be ahead of the curve. If the Fed is caught still increasing the money supply and artificially suppressing interest rates during a period of accelerating growth, inflation will surely become a crisis waiting to happen. The Fed is notoriously slow moving, so this worry is very real. Luckily enough, one unexpected report does not make or break the economy. However, investors should continue to keep a wary eye as purchases end in October and new GDP and inflation reports are announced.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.