Fed's Balance Sheet Vs. U.S. GDP

 |  Includes: SPY
by: Chris Ridder, CFA

Before the Fed's FMOC announcement, the market pundits on TV were guessing about QE3. Should the Fed do it now, latter, or not at all? Seeking Alpha even had a heading "FOMC: No QE3" on its front page, with several articles listed after the announcement.

There is still speculation that the Fed will attempt another quantitative easing, spurred on by the problems in Europe and U.S. housing. One member of the FMOC even dissented in favor of a more accommodative policy (see No Surprises In Statement, Yet A Dove Cries).

All of this had me thinking about how big has the quantitative easing been, and its effects.

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From Q1 2008 to Q3 2011, the Fed has tripled (310%) the size of its balance sheet, while real GDP has grown about 65 basis points (.65%) over this same time period. Yes, that is correct; the Fed's balance sheet expanded by $1.8 trillion while real GDP increased by only $86 billion.

Nominal GDP increased 6.5% or about $925 billion. This means that over 90% of the growth in nominal GDP has been from inflation, with only 9.3% from "real" GDP growth over the last 2.5 years.

The Fed's balance sheet has reached unprecedented heights as a percentage of the U.S. economy. It is just under 20% of real GDP and 17.5% of nominal GDP.

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I have seen reports that when the Fed does permanent open market operations (QE), then the stock market goes up. I checked the quarterly returns from Q1 2008 - Q3 2011and found that even with only 14 observations there was statistical significance.

(ld_SP500 are the returns of the SP500 and ld_MB is the percent change in the money base)

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The problem here is that the coefficient is negative (-.334336). This implies an increase in the money base would decrease stock market returns.Yikes! However, the monthly data, not shown, turned out to be statistically insignificant.

From the above I conclude, that even if QE helps the stock market, it is only for day traders, and long term investors should be more concerned about figuring out the E in P/E rather than QE.

(All data was downloaded from http://research.stlouisfed.org/fred2/.)

Disclosure: I have no positions in any stocks mentioned, but may initiate a long or short position in SPY over the next 72 hours. I receive no compensation to write about any specific stock, sector or theme.