November Members Newsletter: An Obituary for QE

Posted by Alex Frey (@alexhfrey )

This past week, the US economy took a key step toward finally putting the 2008 financial crisis behind us. The Federal Reserved announced the end of its "quantitative easing" program, a monetary life-support program that resulted in the purchase of more than $3 trillion worth of Treasury bonds and mortgages over the past six years, paid for with money that the Fed literally created out of thin air.

While QE is now ending, much about it remains unclear. To what, if any, credit should it be given for the economic recovery in the US? How much is it responsible for juicing the stock market? And, most crucially, what are the implications of its end for the financial markets?

Below, we examine.

QE's Motivations

In a very interesting speech in 2012, then Federal Reserve Chairmen Ben Bernanke laid out the logic for Quantitative Easing. With interest rates already at the "zero-bound" (you can't practically pay someone less than 0% on a loan), the Fed sought to improve the economy through "untraditional means" -- purchasing a set "quantity" (hence the term "quantitative") of longer-term Treasury bonds and mortgage on the open market. Because the Fed can essentially "print money", there was effectively no limit to their ability to do this.

In his speech, Bernanke makes it clear that the primary motive for QE was to lower long-term interest rates. All else equal, this should make companies and households more willing to borrow and spend, and it should increase household and corporate net worth (by pushing up asset prices). This should also increase spending by the "wealth effect" (as people feel wealthier, they spend more).

On the other hand, many were opposed to QE because they feared it would increase inflation as a result of massively increasing the amount of dollars in circulation ("printing money").

QE's Impact on the Real Economy

In the US, the Federal Reserve has a dual mandate to tackle both inflation and unemployment. It has historically interpreted this to mean that the economy should be operating at close to full employment (which really is an unemployment number of a bit more than 5% since there will always be some natural / frictional unemployment as people move between jobs) and that inflation should be around 2% a year. A good starting point to evaluating the impact of QE, then, is looking at how these two metrics have fared since it began.

The below charts show that the Fed is getting close to hitting on both of its targets:

Civilian Unemployment Rate - FRED - St. Louis Fed 2014-11-01 13-36-29.png

Consumer Price Index- Total All Items for the United States© - FRED - St. Louis Fed 2014-11-01 13-58-01.png

Unemployment has notable fallen significantly from 2008. It is hard to say how much of this decrease in unemployment should be attributed to QE, but the data does make one thing fairly clear. The fears that QE would lead to massive hyperinflation as a result of "printing money", which were quite popular in some circles five years ago, now seem overblown. There is little to any sign of increasing inflation in the data, and in fact it would seem like naively you could make the case that headline inflation is actually on a downtrend (which is one reason that the Fed has been able to keep interest rates at 0 even though unemployment now seems close to its normal level). In any case, we have clearly not become Zimbabwe.

This lack of inflation is, at one level, puzzling. Milton Friedman is famous for saying that "inflation is always and everywhere a monetary phenomenon." If QE is, at one level, "printing money", then why has it not led to inflation?

The chart below provides some explanation:

Excess Reserves of Depository Institutions - FRED - St. Louis Fed 2014-11-01 13-33-21.png

The Fed conducts QE by means of purchasing Treasury bonds and mortgages from banks, taking those bonds out of circulation, and then crediting the banks accounts at the Federal Reserve as a result. Theoretically, the banks could issue additional loans as a result of having more reserves. It would be the issuance of these loans that would get more money circulating around in the real economy.

But with rates at 0% even prior to QE, the banks already had all the reserves they wanted, because if they wanted more they could already have borrowed them for free. So reserves were never the thing that was preventing them from making additional loans. They just didn't want to, probably because they were still repairing their own balance sheets and did not want to take on additional credit risk, or because they could not find enough qualified borrowers, since households were repairing their own balance sheets as well.

So QE never directly got any money out into the real economy, where it could circulate. It just "parked" that money in the balance sheets of major banks.

And banks themselves have been hesitant to increase their loans, even with so many excess reserves.

This clip from a recent NPR segmented quoting economist Alan Blinder sums up the issue well: "If you talk to bankers, they say there's no demand for loans. If you talk to small business people and people looking for mortgages, they say credit is tight and they can't get loans. To me, that's the deepest mystery of what's going on in the economy right now."

And also perhaps one of the biggest reasons why the economy, while now having easily surpassed the overall level that it was at in early 2008, has still not caught up to its trend-line growth from the 1990 - 2010 period, as you can see below.

Real Gross Domestic Product - FRED - St. Louis Fed 2014-11-01 13-42-04.png

This matters because it means that while the immediate damage from the financial crisis has now been undone, there seems to be an equally pernicious long-term effect that is very much still there: the economy seems to be growing a bit slower every year than it was prior to the crisis (I say "seems to be" to because of the small size of the sample period, as well as the inherent imperfection of any economic data). Were the economy to have remained on its pre-crisis path, we could theoretically have 10-20% higher living standards than we do today. And, alarmingly, that gap is still growing every year.

So QE has not been enough to return us to our former path of growth, but is it possible that it could actually be the thing to blame for this?

Most economists would say no, but I have heard a couple arguments on the "yes" side. The first is that it may be possible that QE adversely impacts the banking sector by reducing the net interest margin that banks can achieve by borrowing short and lending long, and that this discourages them from lending, which in turn crimps growth.

The second is that artificially "easy" money may hurt productivity by creating "mal-investment" (mis-allocation of resources).

But structural issues, notably a period of consumer de-leveraging following the 08 debt bubble, would seem to be mostly to blame for the anemic growth. And cross-comparisons with regions that have been less eager to embrace unconventional monetary policy, like Europe, also would suggest that QE has had an overall positive impact on growth.

In the end, we can't truly scientifically decide whether QE was effective from looking at the current economy, because we will never know for sure what the economy would look like today in its absence1 . The biggest argument in favor of QE is that things could have been a lot worse without it, but economists will be arguing about that for the next fifty years.

QE's Impact on the Financial Markets

There is slightly less debate about QE's impact on the financial markets then it's impact on the real economy. That's because by Bernanke's own logic, in order for QE to have had any impact on the real economy, it would have had to first lower long-term interest rates.

Here's what those look like, in both real and nominal terms.

ten_year_rates.png

It's impossible to tell just from looking at a chart of course, but most economists that have applied their models to these things have determined that QE has reduced rates below the level they would otherwise be.

This is significant because the long-term interest rate on a risk-free Treasury bond is widely viewed as the "time value of money." The classic way to determine the fair value of any financial asset under the sun is to take the net present value of its future cash flows, using the Treasury yield as a basis for calculating the time value of money. So when Treasury rates go down, that means that you are dividing by a smaller value, which pushes up the value of every financial asset under the sun.

If this sounds too theoretical for you, there are many practical mechanisms with which lower interest rates will increase stock prices.

  • When debt is cheap, companies can profitably issue it and use the proceed to buy back shares of their own stock, which in turn pushes their stock price up.
  • When interest-rates are low, Private-equity companies can issue cheap debt to buyout companies, which pushes equity prices up.
  • When rates are low, investors like pension funds may find that they are unable to reach their "hurdle rate" by investing in fixed-income securities, so they will "reach for yield" and buy equities, which pushes prices up.

On an even more primitive supply and demand level, it is hard to imagine that the Fed could purchase more than $2 trillion of financial assets with "created" money and not broadly push up the price of financial assets.

Here's how the S&P 500 performed in the years immediately before, and then during, QE.

S&P 500© - FRED - St. Louis Fed 2014-11-02 19-47-58.png

Does this mean that we are in a "bubble"? I don't think that's the right term to use. You get a bubble when the price of a particular asset gets so out of whack with its intrinsic value that the only reason someone would ever buy it would be to flip it to someone else. What has happened over the last few years is, in my mind at least, more accurately described as a slow but fairly rational "pricing-in" of low interest rates. Stocks look "expensive" relative to where they have traded in the past -- yes -- but that might be mainly because Treasury bonds do too!

It's also important to remember that QE was not the only thing driving stock prices higher. Corporate profit margins are also at record highs, and that matters too (see the blog post here for more).

Where to From Here?

With the end of QE, should we fear that the punchbowl is being removed from the party?

There are at least four reasons why it's probably not time to panic:

1) The end of QE is one of the least surprising events in years. The Fed has taken great pains to warn the markets about it years before it happened. This means that the markets have already anticipated it happening, and, if they are at all "efficient", priced it in. That treasury rates are still quite low, even though the Fed has been slowly reducing the size of QE for some time, is an indication that the markets are not too afraid of what is going to happen next.

2) The interest rates that the Fed can directly control -- short-term rates -- are still at 0. This ensures that banks will be able to get all the reserves that they need, and it weighs down the yield curve.

3) Other central banks may be picking up the liquidity-provision slack from the Fed. The Japanese central bank just last year launched an aggressive QE campaign. Europe could follow. Some of this newly created money will probably find its way back into US Treasuries and stocks.

4) To some extent, the Treasury is also picking up slack from the Fed. The US budget deficit has been declining sharply since 2008 as a result of improvements in the economy as well as the impact of the "sequester." This creates less supply of new Treasuries that need to get absorbed by the market -- a somewhat similar impact to what would have happened had the budget remained at its previous level and the Fed continued buying Treasuries (the difference is that government spending is smaller under the current scenario).

5) It's not clear that QE's impact was as large as some commentators like to claim. It probably pushed asset prices up a bit, but it might not have been the most significant thing doing so. It probably improved the real economy on the margins, but that is even less clear. If QE had only a relatively small impact, then taking it away is not likely to be a catastrophe.

An Assessment

It seems fairly certain that what QE was and was not responsible for will be a subject for economists to debate for the next century. Even today, there is not universal agreement on what got us into or out of the Great Depression, and QE will be no different. 

That will be a fascinating debate to watch play out, but for our self-interested purposes, it is ultimately not the most important question. We want to know if the end of QE warrants a significant change to our portfolios. And to that, the answer seems to be no. 

To change our investing strategies, we would have to believe either QE was the significant thing propping up the real economy, or asset prices. The first of these does not seem likely, since the sole of QE's likely impact on the economy came from a marginal lowering of long-term interest rates. The trillions of dollars of reserves it created never left the banking sector. The second is a bigger risk, since it does seem that QE did push up asset prices. But was far from the only factor, and its end has been so choreographed that it is hard to believe that the markets could not be prepared for it.  

So we're going to go on sticking to build a low-cost, diversified, and dynamically-allocated portfolio and let the economists sort out the rest. 

Performance

IvyVest Model Benchmark
One Month 1.9 1.9
Three Month 0.5 0.6
Six Month 2.7 3.2
One Year 7.7 7.5
Three Year 10.6 8.7
Five Year 11.7 10.6
Ten Year 11.3 8.0
Twenty Year 11.3 8.3
Since Inception 13.2 10.6

  1. The pro-QE camp would cite the Great Depression as a data point on what happens when you get systematic de-leveraging without QE. Fair point I suppose, there were plenty of other differences as well (FDIC was not yet in place, the bank run got worse, the Fed actually raised interest rates, we were still on gold standard for a while, etc.).  


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By Alex Frey