At the end of six years of QE programs, the Fed had purchased $3.9 trillion of mortgage-backed securities and Treasury bonds, increasing its balance sheet from $800 billion to $4.7 trillion. This represents 26 percent of U.S. Gross Domestic Product (GDP), a historically high amount, relative and absolutely. But the Fed is not alone. The Bank of Japan just announced its QE program will be expanded and its balance sheet is already 57 percent of Japan’s GDP. The European Central Bank has just started a QE program and its balance sheet, at 21 percent of Euro GDP, will certainly get larger.
What did the Fed do before QE? For 95 years of its 101-year existence, the Fed exerted monetary control through short-term interest rates, supplying credit to the banking system to lower rates or withholding credit to increase rates via open market operations. The Fed also has the right to change reserve requirements for the banking system, the amount of cash and other liquid assets banks need as a percent of deposits, and the discount rate, the amount the banks pay to borrow reserves from the Fed. The Fed also has used selective credit controls and moral suasion. The short-term interest rate targeted by the Fed is called the “Fed funds” rate which is based on interest rates for overnight loans between U.S. banks. This rate was fairly easy to manipulate when there were $30 billion-$40 billion of excess reserves in the banking system. At present the Fed is targeting a range of 0 to .25 annual rate for the Fed funds rate.
What are the implications of Fed monetary policy since the new unconventional tool of quantitative easing has been initiated? The big question now is whether the Fed will be able to raise the Fed funds rate in the future. As the Fed went through the three QE programs, it purchased bonds from banks and others and paid for them by crediting bank reserve accounts at the Fed. To the banks these reserve balances were as good as cash that could be lent out or invested. Because of the slow-growth economy, low loan demand, Dodd-Frank and other issues, the banks left much of the reserves at the Fed recreating $2.7 trillion of excess reserves, those not needed to support deposits. With that magnitude of excess funds in the system, the Fed will find it challenging to raise interest rates via traditional methods. There is no longer a viable Fed funds market. Plus the Fed has already announced that it will maintain its $4.5 billion balance sheet so selling a lot of bonds to drain liquidity from the system is not an option. What to do? The Fed could raise the interest rate on bank reserves. However, this may not be politically feasible because it would be boosting bank profits, including those of foreign banks with U.S. deposits, with no risk on the part of the banks. Another alternative would be to target other short-term bank borrowing markets such as the Eurodollar, Libor, commercial paper and repo markets.
It is difficult to assess the effectiveness and impact of the QE programs as we never know what would have happened if there had been no QE programs. It is also difficult to differentiate between the impact of the QE programs and the zero interest rate policy the Fed has maintained since late 2008. But certainly the QE programs have reinforced expectations that short-term interest rates would not be raised as they have not been to date. The S&P 500 closed at an all-time high in November, the U.S. Treasury 30-year rate and mortgage rates were below 4 percent, the yield on the 10-year Treasury was below 2.5 percent, unemployment was 5.9 percent and the Shiller Case housing index has rebounded 25 percent since the lows of 2011. So it has been successful by some measures. But, the economy has grown only by 2.2 percent annually since the recession ended in June 2009, way below past economic recoveries. Inflation has also remained subdued, averaging 1.4 percent annually since the recession ended. The Fed has a 2 percent inflation target and inflation has been below the target for 29 straight months. The Fed remains concerned about the economy and the deflation that Europe and Japan have already experienced.
Some think that QE is a dangerous monetary tool because of unpredictable side effects. One would include igniting inflation and inflationary expectations beyond the Fed’s 2 percent target if banks stimulate the economy with their $2.7 trillion of excess reserves. A second would be financial instability as investors take on more risk reaching for yield and creating asset bubbles. A third is that the huge Fed balance sheet may interfere with conventional monetary policy and tools in the future. Only time will tell whether the side effects and effectiveness of the QE programs are understated or overstated. The debate may go on for years.
Whenever the Fed choses to do so, the task of raising interest rates has gotten more difficult and risky. When will that happen? The consensus seems to be mid-2015 at the earliest and perhaps not until 2016. When it happens, let’s just hope that the QE punch bowl doesn’t leave the economy and investors with a hangover. Or the punch bowl may need to be refilled (QE4) to keep the party going.