EmailThe Fed may or may not announce another round of quantitative easing on Wednesday. There are valid arguments for and against. Even if the Fed does act, the impact will be limited.
The Debate
The Federal Reserve has conducted two rounds of quantitative easing (QE) – buying debt securities in the open market. Such actions have the effect of increasing credit in the financial system, as the Fed simply creates the credit necessary to buy the securities.
The intent is to stimulate economic activity in part by lowering interest rates and in part by increasing liquidity and money supply.
The debate as to whether or not the Fed should initiate another round of QE at the policy meeting on Wednesday can be broken down as follows.
Argument in favor:
1) The Fed has to do everything possible to address its statutory mandate to seek maximum employment and price stability.
Yes, that pretty well summarizes the argument in favor of another round of QE. It may be enough. Employment conditions are unsatisfactory and Fed Chairman Bernanke has long been known to believe that QE is a necessary measure when an economy is in the throes of a long-term credit cycle.
Argument against:
1) Prior actions have had mixed results. Another round of QE will have less impact and simply make it more difficult for the Fed to eventually unwind the resulting credit created. The costs exceed the benefits.
Yes, that pretty much summarizes the argument against further quantitative easing. The first round of QE probably had some critical impact, but the second round had far less beneficial impact, and a third round would have even less impact.
QE1 and QE2 Before and After
The table below presents the key economic variables before and after the first two rounds of quantitative easing, along with current conditions.
| Start of QE1 | End of QE1 | Start of QE2 | End of QE2 | Current | |
|---|---|---|---|---|---|
| 10-yr yield | 3.35% | 3.84% | 2.67% | 3.18% | 1.55% |
| Six-Month M1 Growth | 14.8% | 6.2% | 9.1% | 13.0% | 8.1% |
| Six-Month M2 Growth | 6.5% | 1.3% | 6.5% | 6.8% | 6.8% |
| Unemp. Rate | 6.5% | 9.8% | 9.5% | 9.1% | 8.1% |
| 6-Month Real GDP | -6.3% | 3.2% | 2.5% | 1.3% | 1.8% |
Each variable is discussed below.
Interest Rates
There is no clear indication that the first two rounds of QE actually lowered interest rates.
In fact, the 10-year note yield rose over the course of both QE1 and QE2.
It can be argued that the anticipation of quantitative action pushed rates lower ahead of the actual bond purchases, but even that assumption wouldn’t change the conclusion that neither QE1 nor QE2 had much impact on lowering rates.
Instead, this 20-year chart of the 10-year note yield shows that rates have been coming down for years, independent of Fed action.
The 10-year note yield is currently at 1.55%. The 15-year fixed mortgage rate is currently at 2.90%.
Rates are already extremely low. It is by no means clear that even lower rates will finally stimulate the economy, or that another round of QE will even result in lower rates.
Money Supply
The direct impact of QE on money supply growth is difficult to assess, because bank credit extension is the primary driver of money supply creation.
It might appear that QE1 had little or no impact, but the slowdown in money supply growth was caused by the contraction in bank credit, as shown in the chart below.
The first round of quantitative easing probably prevented a serious decline in money supply, and for that reason it was effective.
There is an argument for another round of QE based on the current moderate money supply growth rates, but it is not compelling, particularly as bank lending has picked up recently and may be sufficient to promote solid monetary growth.
GDP and Unemployment
Ultimately, lowering interest rates or increasing money supply is done with the intent of boosting economic growth and employment.
The data are inconclusive as to the impact of the first two rounds of QE.
Real GDP growth turned around during and after QE1. It probably had an important impact on stabilizing the economy. The data suggest that QE2 had less of an impact. Economic growth actually turned lower.
The unemployment rate, which lags overall economic activity, rose during QE1, but that was unavoidable. The unemployment rate declined at a slow, steady pace after that, seemingly independent of the Fed’s actions, and has actually declined at a faster rate subsequent to QE2 than during QE2 and immediately after.
The unemployment rate has declined from 9.1% in June of 2011 after the end of QE2 to 8.2% today.
On Balance
QE1 was conducted at a time when there was a risk of an even worse credit implosion and economic collapse than ultimately occurred. QE1 was probably necessary and effective.
The second round of QE had less impact. Money supply growth picked up only modestly and there was no clear impact on the trend in unemployment, GDP, or interest rates.
Overall, the Fed is doing fine on price stability and keeping long-term rates moderate.
Stock Market Reactions
Stock market participants are convinced that QE3 will boost stock prices, or at least reduce the downside risk to prices. It isn’t clear that this is the case.
Here is the chart showing the S&P during the first two rounds of QE.
The stock market did rise substantially during QE1, and as noted above, QE1 was probably effective at stabilizing the economy, credit conditions, and liquidity. The increased confidence probably helped boost stock prices.
The stock market also rose during QE2, but the increase in the stock market during that time also occurred while profits for the S&P 500 in aggregate were rising sharply.
| Qtr Prior to QE2 | During QE2 | During QE2 | During QE2 | Qtr After QE2 | |
|---|---|---|---|---|---|
| S&P Yr/Yr Profit | 33% | 34% | 19% | 12% | 18% |
Seasonal factors and strong profit growth were also boosting stock prices, which had lagged relative to profit gains following the recession. It is debatable to what degree QE2 was a factor in the stock market rally during that time.
At present, profits are stagnating. Profits for the second quarter will be up about 5%, but profits are flat excluding some anomalies in the banking sector. Third quarter profits are forecast to be flat to down slightly. The outlook for profits, in our view, will ultimately outweigh any beneficial impact from increased liquidity due to QE3.
What It All Means
Whether the Fed announces another round of QE on Wednesday is a close call. It depends on the personal leanings of the individual members of the policy committee.
If the Fed does act, it will be because the unemployment rate is still too high, and the Fed feels a need to do all it can to support economic growth.
Another round of QE3, however, probably won’t have much economic impact through lower interest rates or increased money supply growth. It is far from certain that it will have any significant impact on the unemployment rate.
It is also unlikely that QE3 will provide a sustainable boost to the stock market. Over time, the S&P 500 index level will be a function of profit trends. If QE3 has limited impact on the economy, it will have limited impact on profits.
The first round of quantitative easing was necessary. The second round was far less effective than the first. A third round would be even less effective, and might not be worth it in the long run.
Founder and Chairman, Briefing.com
