The "End of QE II" story has turned into the biggest source of market misperception in decades. I watch and read financial news constantly. Each day goes by with no one correcting the many factual errors on this subject.
The QE II matter is probably the most important market issue, so getting it right should have a big payoff. The story is too big for one of my regular evening articles, so I will continue with my planned series. Tonight's subject is how QE II really works and why it is not ending.
I realize that there are many other questions -- the effect of market perceptions, the apparent, but deceptive correlations, and even the effect of misperceptions. I will take up these questions in due time. For the moment, you can check out a summary of my past QE II articles.
A Simple Illustration
Let me start with a simple and more traditional illustration of Fed policy -- cutting interest rates. As the Fed reduced rates, we would say that it was a cycle of easing. If the Fed kept rates at a very low level, we would describe it as a continued easy money policy, not the end of easy money.
The quantitative easing programs took place when the Fed had already exhausted the traditional rate cutting at the short end of the yield curve. The Fed will complete the planned purchase of $600 billion in Treasuries by the end of June. The purchases are the equivalent of interest rate easing.
Stopping Fed purchases does not end the period of easy money. That will happen only when the Fed reduces its balance sheet, something that is not currently planned.
To emphasize -- the market believes that the effect of the Fed policy comes only from fresh purchases of Treasuries. This incorrect conclusion has been widely disseminated by various sources, including those who should know better.
The reality is that the easy money policy continues as long as the Fed balance sheet is not reduced.
To understand this very important distinction, you need to know how a fractional reserve banking system works.
How it does NOT work
What is definitely not happening is the thing you hear and read every day. People think that the dollars from the Fed buying of Treasuries somehow make their way into stocks and commodities and has fueled a speculative bubble. This is a know-nothing attitude, which you will easily understand if you think about it carefully and objectively.
The Fed buys bonds from a dealer. From the dealer's perspective, the transaction in no way adds to the ability to make other purchases. If a dealer bank wanted to buy grain or stocks or oil futures, this can be done with very little margin and using bonds as collateral. The Fed transaction has no effect.
How it does work
The Fed purchase of Treasuries from dealers increases the monetary base. The money creation effect -- and this is the "printing money" you hear so much about -- is the reciprocal of the reserve requirement, currently ten percent in the US. This means that $600 billion in QE II buying has created the potential for $6 trillion in new money. This potential has not been realized.
The Wikipedia articles are fairly accurate but slender introductions that provide a starting point (here and here). The best explanation of QE II is Mark Thoma's description. It is worth your time to read the full article, but here is the key conclusion:
Since it is predominantly long-term rates that determine business investment, the purchase of new homes, and the purchase of consumer durables such as cars and refrigerators, this was of concern within the Fed. But the reason for this was never fully understood, and the crisis diverted attention away from this issue. However, one way the Fed can potentially overcome this problem is to buy and sell longer term Treasury bonds, i.e. those that exist on the long end of the yield curve, to bring long term rates up or down as desired.
This is, essentially, all that QEII is. It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets.
The Effect of QE II
It is pretty much impossible to know what the effect of QE II has been. The key question is what interest rates would have been in the absence of this policy. Most economists estimate that the rates would have been about ten basis points higher in the middle of the curve, but no one can prove the case. In fact, rates moved higher after the policy was implemented, a deceptive but seductive estimate of the effect.
Other effects came from psychology. More on that in future articles.
The actual effect comes from increased bank lending. From the Fed's perspective, the policy did not sufficiently stimulate lending. The result was a reduction in the velocity of money, explained effectively (and with great charts) by two of our favorite professors, James and Menzie at Econbrowser.
I made similiar arguments in refuting some of the worst commentary on the subject.
The End of QE II?
One would think that the Fed Chairman would be the best source on whether QE II is ending. Ben Bernanke covered this question carefully in the Q&A that was part of his recent press conference. The answer is technical and seemed to escape the notice of most. Here is the first part of his answer:
CHAIRMAN BERNANKE. As I—as I’ve noted and as you’re all aware, we are—we
are going to complete the program at the end of the second quarter, $600 billion. We are going
to do that pretty much without tapering. We’re just going to let the purchases end. Our view is
that—based on past experience and based on our analysis—is that the end of the program is
unlikely to have significant effects on financial markets or on the economy, the reason being
that, first—just a simple point that we hoped we have telegraphed today—we hope we have
communicated what we’re planning to do. And the markets have well anticipated this step. And you would expect that policy steps which are well anticipated by the market would have
relatively small effects because whatever effects you’re going to have would have already been
capitalized in the financial markets.
I note that Bernanke seems to be out of touch with market anticipations!
Let us turn to his real expertise [emphasis added]:
Secondly, we subscribe generally to what we call here the stock view of the effects of securities purchases, which—by which I mean that what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchase, but rather the size of the portfolio that the Federal Reserve holds. And so, when we complete the program, as you noted, we are going to continue to reinvest maturing securities, both Treasuries and MBS, and so the amount of securities that we hold will remain approximately constant. Therefore, we shouldn’t expect any major effect of that. Put another way, the amount of ease, monetary policy easing, should essentially remain constant going forward from—from June. At some point, presumably early in our exit process, we will, I suspect, based on conversations we’ve been having around the FOMC table, it’s very likely that an early step would be to stop reinvesting all or part of the securities which are coming—which are maturing. But take note that that step, although a relatively modest step, does constitute a policy tightening because it would be lowering the size of our balance sheet and, therefore, would be expected to essentially tighten financial conditions.
To emphasize, the halt in new buying is not tightening, especially if maturing securitites are reinvested.
I cannot do the full investment conclusion from this single article. We must consider the perceptions as part of the effect. Some perceptions were intended by the Fed. Others are completely mistaken.
This is an important opportunity for investors who take the time to understand the issue. As I noted in our weekly update, it is a time to pick and choose great stocks at great prices over the coming month.
A Final Note
QE II will end when the purchases are unwound. There is an important difference between the end of new purchases and the end of QE II. It is easy to be sloppy in discussing this, and everyone (including me) lapses into the popular perception on occasion when we should be much more careful.