The United States Federal Reserve has been conducting open market operations in the financial markets since 2008 in order to drive down interest rates and promote economic growth following the 2007-08 financial crisis. The subsequent recession, dubbed the Great Recession, destroyed $19 trillion in household wealth and nearly 9 million jobs. The highly controversial quantitative easing (QE) program, which refers to the process of introducing new money into the money supply, has been effective in promoting US recovery over the past six years.
What has divided analysts, however, is the long-term impact of central bank stimulus, and whether the current recovery could be considered self-sustaining. Additionally, it took several years before the economy showed any real signs of progress. The grim economic picture in the years following the crisis resulted in the expansion of monetary stimulus in 2010, 2011 and 2012.
The Federal Reserve introduced quantitative easing in measured steps. The first wave of stimulus, dubbed QE1, was initiated in November 2008 when the central bank announced plans to buy $600 billion worth of mortgage-backed securities. QE1 lasted until March 2010.
The second round of quantitative easing, commonly known as QE2, was announced in November 2010 and concluded in June 2011 after the Federal Reserve had purchased $600 billion worth of long-term Treasury securities.
The third and final round of quantitative easing (QE3) was announced in September 2012, when the Fed promised to purchase mortgage-backed securities and US Treasuries at a pace of $85 billion per month for as long as needed. The central bank said it would maintain its open-ended commitment until the labor market showed signs of improvement.
Scaling back stimulus
The Fed began to scale back the pace of asset purchases in December of last year under then-Chairman Ben Bernanke. The Federal Open Market Committee (FOMC) has voted to pare asset purchases by $10 billion per month at each meeting since, including the March meetings when the US economy was experiencing its worst economic contraction since 2011.
The US economy contracted at an annualized rate of 2.1 percent in the first quarter, as inclement weather weighed on output in virtually every sector of the economy.
Earlier this year the Fed announced it would likely end its record quantitative easing program in the fall, following a series of upbeat economic reports showing the US economy was gaining momentum. By paring asset purchases by another $10 billion at the September 16-17 policy meetings, the Fed has brought down the total of its monthly asset purchase facility to $15 billion. The markets widely expect the Fed to end its QE program at the October Federal Open Market Committee policy meetings with one final reduction of $15 billion.
“If the economy progresses about as the Committee expects, warranting reductions in the pace of purchases at each upcoming meeting, the final reduction would occur following the October meeting,” the minutes of the June FOMC policy meetings revealed.
The central bank, which has held its target for the overnight rate at a record low of 0.25 percent since December 2008, is not expected to begin lifting rates until at least the second quarter of next year.
Since implementing QE, the Fed’s balance sheet has swelled from under $1 trillion to more than $4 trillion, an all-time high.
Impact of QE on the Financial Markets
The Fed’s bond buying program had an immediate impact on the financial markets, as investors rallied behind the central bank’s commitment to economic growth following the financial crisis. Since the implementation of QE, the equities markets have surged, with the benchmark gauges setting multiple record highs.
Since hitting its bear market low of 676.53 on March 9, 2009, the Standard & Poor’s 500 (S&P 500) has rallied more than 190 percent. In the process, the S&P 500 set multiple record highs, having climbed more than 26 percent in 2013 alone, the index’s best annual performance since 1997.
Since hitting its bear market low, the S&P 500 has enjoyed one of its best bull markets since 1929, according to Bank of America.
The Dow Jones Industrial Average (DJI) is another major benefactor of central bank stimulus. This gauge of 30 large enterprises on the New York Stock Exchange hit rock bottom on March 6, 2009, reaching a bear market low of 6,443.27. That reflected a more than 50 percent drop since October 9, 2007, its previous high.
Since bottoming out in March 2009, the Dow Jones Industrial Average has rebounded more than 165 percent. The index had a stellar 2013, gaining more than 23 percent.
Not everyone is convinced that monetary policy had a direct impact on the stock market. According to a 2013 study from McKinsey Global Institute, there was little theoretical and empirical evidence linking QE and stock prices.
While clearly in the minority, researchers at McKinsey cannot doubt the impact QE has had on expectations. The Federal Reserve’s forward guidance instilled in the markets the expectation short-term interest rates would remain near zero for an extended period, which in turn influenced greater risk taking in the equities market. Everyone knew QE would end eventually, but that didn’t stop investors from taking advantage of accommodative monetary policy.
Higher equity prices have also boosted household wealth, albeit at the upper end of the American socioeconomic strata. US household wealth reached a record high earlier this year, driven by rising house prices and a more lucrative stock portfolio. According to USA Today, household wealth increased $1.5 trillion in the first quarter of this year to reach a staggering $81.8 trillion, driven in part by a $361 billion gain in stock and mutual fund holdings.
These figures corroborate the findings of a 2011 study by Harvard Economist Martin Feldstein, who estimated that a 15 percent rise in stock prices would increase household wealth by approximately $2.5 trillion.
Rising household wealth, among other factors, has also lifted consumer consumption growth, a critical aspect of any economic recovery. Consumer spending, which accounts for more than two-thirds of the US economy, grew at an annual rate of 2.5 percent in the second quarter of 2014. As a result, the broader economy expanded 4.6 percent annually in the second quarter, its fastest pace in two-and-a-half years.
The markets in a post-QE world
The end of quantitative easing is a significant milestone for the United States because it means the Federal Reserve has enough confidence in the economy to withdraw its support. The end of QE also suggests the economic recovery was finally self-sustaining after years of accommodative monetary policy.
Speculation about when QE would end has gripped the financial markets since mid-2013 when Chairman Ben Bernanke first signaled at the prospect of bond tapering, the process by which the Federal Reserve gradually reduces its QE program. The gradual winding down of QE, it was feared, would boost interest rates and cause a broad retracement in the equities markets.
Underlying these concerns was the reality that, without QE, the market’s performance would reflect economic fundamentals. Under QE, stocks and bonds performed exceptionally well despite below-trend economic growth. Remove QE from the equation and investors’ portfolios would be exposed to subpar GDP growth, stagnant earnings, a fledgling housing market, shaky consumer confidence and other negative influences impacting the US economy.
Nine months after the Federal Reserve initiated its first bond taper, the stock markets appear to have weathered the storm of negative speculation. Stocks continue to perform well and the markets have yet to experience the broad retracement several analysts were prognosticating. This is because investors have grown more comfortable with the end of QE, despite expectations for a broad correction.
Still, investors have had plenty of time to plan for the inevitable conclusion of QE. They also have several tools at their disposal to protect against a sharp decline in stock prices, such as trailing orders, options and other hedge tools that can help minimize risks in an uncertain environment.
Ultimately, the market’s performance will reflect whether the US
economy has improved as much as the key economic indicators have reported. Although even these are hit-and-miss (i.e., housing, income), the general picture suggests the economy is improving. The post-QE environment will surely test the hypothesis that the US economy has entered a phase of self-sustaining recovery.
The path toward policy normalization suggests the central bank is growing more confident in the US economy. However, the latest batches of economic data paint a mixed picture of the US growth engine.
On the one hand, US unemployment has plunged 1.1 percentage points over the previous 12 months and has settled near six-year lows. Consumer confidence is rising as the labor market recovery deepens, and corporate earnings remain strong.
On the other hand, stubbornly weak earnings growth has raised concerns about the quality of US jobs. It has also kept the housing recovery contained, as rising mortgage rates and higher house prices have eroded modest earnings growth.
Although the Fed is expected to raise interest rates next year, long-term interest rates are expected to trend below the historical average, which suggests central bankers won’t rush to tighten policy amid the recovery.
Heading into the fourth quarter of 2014, the economy appears to be gaining traction, as investors have maintained a healthy risk appetite despite geopolitical uncertainties and problematic recoveries in Europe and Japan.
The US economy is forecast to grow 2 percent to 2.2 percent this year, according to revised estimates from top central bank policymakers. The Federal Reserve expects the economy to gather pace in 2015, growing at a rate of 2.6 percent to 3 percent.