Ever since the FOMC surprised Wall Street with its announcement of open ended QE3 focusing on mortgage backed securities there has been a great deal of speculation and doubt about whether QE3 will ultimately reach its goals of lowering unemployment and reducing the risk of below target inflation. However, history shows that such a program can improve the employment situation and raise inflation. Open ended quantitative easing has been done before with a major global economy and was successful, albeit for a very short period of time ... and therein is the rub. Here is what history shows us ...
After a series of ineffectual monetary policies which included a zero interest rate policy from February of 1999 through August of 2000, the Bank of Japan introduced quantitative easing that was open ended and linked to Japan's Consumer Price Index. This open ended quantitative easing started in March of 2001 and continued for five years into March of 2006. Japan had been unsuccessfully fighting deflation off and on since 1995 and deflation was the Bank of Japan's major concern, similar to the unemployment rate and Thursday's FOMC announcement. When the Bank of Japan announced their open ended quantitative easing program they promised to maintain the policy until the core CPI rose on a year-over-year basis for several months and otherwise proved to sustain itself above zero. By March, 2006 Japan's CPI had been rising steadily for four years and finally held above zero for several months.
Japan's Inflation rate (CPI) 1999-2010: source CIA World Factbook
Perhaps what has encouraged the FOMC to target the unemployment rate is that although the Bank of Japan's quantitative easing was targeting deflation it also helped to reduce Japan's unemployment rate.
Japan's Unemployment Rate 1999-2010: source CIA World Factbook
Although the Bank of Japan's open ended quantitative easing program is not identical to the QE3 announced by Chairman Bernanke, it is historically a close enough match that perhaps we can learn something by studying the results of Japan's effort and the price action of their equity market. For one, based on history it's reasonable to conclude that the FOMC will be successful in reducing the U.S. unemployment rate. It's also reasonable to conclude that QE3 will increase the U.S. inflation rate. Both were achieved in Japan in the early 2000's. However, for both statistics it was about a year before positive results were seen, and five years before the central bank believed their actions resulted in a sustainable economic improvement. Thus, QE3 is likely to be with us for some time. However, many investors have assumed that quantitative easing will result in a sustainable advance in the equity markets. The example of Japan and their open ended quantitative easing shows that this is not an accurate assumption. Nor should it be assumed that the FOMC's success during QE3 will be sustainable once quantitative easing has ceased.
In the first chart below we have illustrated Japan's Nikkei 225 index and highlighted the period of zero interest rate policy during 1999 and 2000, as well as the five-year time period of open ended quantitative easing from 2001 two 2006. It's apparent their equity market had both rallied and declined substantially while quantitative easing was in progress. The second chart below may answer why. Despite Japan's being the second largest economy in the world at that time, the Bank of Japan's quantitative easing did not make their equity market immune to global pressures. The rise and fall of the Nikkei 225 matched the rise and fall of the S&P 500 equity index, showing that their equity market was driven by the same forces that control the U.S. and global equities. While it may not be fair to compare the lone efforts of the Bank of Japan to the combined efforts of the Federal Reserve and the ECB, history shows that natural market forces and not central banks determine the equity markets long-term trend.
Nikkei 225 Index 1982 to Present
Nikkei 225 Index with S&P 500 Index Overlay
It should also be noted that in less than a year after the Bank of Japan ceased their open-ended quantitative easing the unemployment rate began to rise, and in less than two years the consumer price index was declining back to deflationary levels. Despite their best efforts and a massive amount of money the Bank of Japan was unable, and is still unable to affect a sustainable change to Japan's economy. We believe that past experience in the United States with QE1 and QE2, combined with Japan's history of open-ended quantitative easing suggests the same should be expected from QE3. It's very likely to reduce unemployment and boost inflation but history shows that the benefits of quantitative easing are more likely to be temporary than permanent. If the economy could support itself and grow unassisted, the Fed wouldn't be taking such extreme action as buying an additional $40 billion of mortgage backed securities each month. Quantitative easing, here or abroad, has yet to prove it can result in sustainable economic growth.
10-Year U.S. Treasury Yield and S&P 500 Index Weekly
There is another subject worth expanding on from the FOMC press release. A few comments within the press release suggest that the FOMC is still concerned that inflation is too low and may be somewhat susceptible to falling into a deflationary environment. At the end of the second paragraph, the FOMC states "The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective." and starts the third paragraph with "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee …" Then, what caught our eye was after reading these two sentences is that the third paragraph ends with "These actions, … should put downward pressure on long-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative." [Emphasis added]
An inflation rate of two percent or below in and of itself should keep downward pressure on long-term interest rates. We know, and we are certain the Federal Reserve knows, that during periods of quantitative easing interest rates will correlate with equities. During both the recent QE1 and QE2 rising equity prices correlated with rising yields on U.S. Treasury's as is illustrated in the chart above. The same occurred in Japan during their period of quantitative easing; yields on Japan's long-bond correlated with their equity market. That correlation between yields on long-term Treasuries and equities may have been adversely affected by Operation Twist as can be seen in the above chart. But, Operation Twist is scheduled to end by the end of 2012. The bottom line is that if the Federal Reserve wants to keep interest rates low and equity prices high at the same time it may need to continue Operation Twist or something similar to artificially support Treasury prices at a greater rate than market forces.