It doesn’t happen very often, but from time to time someone at the Fed makes a truly extraordinary speech. When that happens you had better be paying attention. On March 4th, Vice Chair Janet Yellen made such a speech. It was entitled Challenges Confronting Monetary Policy.
This speech was remarkable – and remarkably frank – in explaining the purpose of Quantitative Easing, how effective it is thought to be by its architects, and how long it is likely to go on. The last point, how long it is likely to go on, is particularly important because that is how long asset prices can be expected to continue appreciating.
First of all, it is useful to remember how monetary policy is supposed to work. Businesses will invest so long as the return they expect to make exceeds the rate of interest at which they must borrow. Normally, during a recession, when the expected rate of return is low, the Fed can lower the interest rate (or hurdle rate) to encourage more business investment and economic growth. Likewise, during a boom, when the expected rate of return is high, the Fed can increase the interest rate so as to discourage investment and slow the economy down to prevent inflation. That’s the way monetary policy is supposed to work. (Of course, in a Capitalist economy there is no monetary policy. For better or worse, the economy adjusts by itself without government intervention.)
There is no limit as to how high the Fed can increase interest rates to slow the economy down. There is, however, a limit as to how far rates can be cut. That limit is 0%. Once the Fed has lowered the interest rate to 0%, it can’t lower it any further. That’s as far as monetary policy can go – at least as far as it can go using conventional means. Thus, once the Fed reduced the short-term rates to 0% in 2008, monetary policy, as it had been conducted up until then, was exhausted. That is something that had never before occurred during the Fed’s nearly century-long existence. And, even with short-term rates at 0%, the economy still continued to deteriorate.
Here we must stop and ask why businesses were still unwilling to invest when the hurdle rate was zero. The answer is that any investment would have been loss-making even with the cost of borrowing at 0%. And why was that? It was because the fifty-fold explosion of credit that occurred between 1964 and 2007 - during the years after the United States broke the link between dollars and gold – had created an economic bubble characterized by excess capacity and asset prices that were overly inflated relative to the purchasing power (i.e. the income) of the public. When such a bubble pops, there are no profitable investment opportunities even if money can be borrowed for free.
It was at that point that unorthodox monetary policy, otherwise known as Quantitative Easing, began. The Fed is now printing 85 billion new dollars each month and using that money to purchase long-term government bonds and mortgage-backed securities. This positively impacts the economy in two ways: 1) by pushing down interest rates on long-term debt and, 2) by pushing up asset prices and, thereby, creating a wealth effect.
To quote Vice Chair Yellen:
“The purpose of the new asset purchase program is to foster a stronger economic recovery, or, put differently, to help the economy attain “escape velocity.” By lowering longer-term interest rates, these asset purchases are expected to spur spending, particularly on interest-sensitive purchases such as homes, cars, and other consumer durables.”
“…even if the interest rate channel is less powerful right now than it was before the crisis, asset purchases still work to support economic growth through other channels, including by boosting stock prices and house values. The resulting improvement in household wealth supports greater consumption spending.”
Is it working? Yes. It undeniably is! The stock market is back at all time highs, the property market is turning around and car sales are strong. It is equally obvious, however, that all of these good things will go into reverse as soon as the Fed stops printing money and buying assets.
But when will that be? The Vice Chair provides some very useful guidance: the Fed won’t stop until there is “a substantial improvement in the outlook for the labor market.”
The unemployment rate was 7.9% when she made that speech. How substantial is a “substantial improvement”? We are told that the FOMC considers the longer-run normal rate of unemployment to be 5.2% to 6.0%. We are also told that most FOMC participants expect “only a gradual decline in unemployment over the next two years to about 7% by the end of 2014.” Does that suggest QE will go on beyond the end of 2014? It suggests it might.
The Fed has committed to keeping the federal funds rate “at the effective lower bound” (i.e. 0%) … “at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more that a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.” No precise unemployment rate has been given as to when the Fed will end QE. Therefore, we can only assume that QE will continue until the unemployment rate is at, or rapidly moving toward, 6.5%. How long could that take?
Again, we are given some very helpful guidance:
“Plausible, albeit uncertain, estimates of the ultimate economic effect of asset purchases can be obtained from simulations of the Board’s FRB/US model. Such simulations suggest that a hypothetical program involving $500 billion in longer-term asset purchases would serve to lower the unemployment rate by close to ¼ percentage point within three years while keeping inflation close to the Committee’s 2 percent objective.”
Do the math. If $500 billion of QE reduces the unemployment rate by ¼ percentage point, given that the unemployment rate is now 7.7%, it would require $2.5 trillion of QE ($500 billion multiplied by 5) to reduce the unemployment rate by 1.25% to 6.45%. That suggests QE could go on at its current rate of $85 billion a month (or $1.02 trillion a year) well into 2015.
There are no guarantees. Nothing is carved in stone. Nevertheless, the signals being sent by the Vice Chair of the Fed are extraordinarily bullish for the stock market. Even if QE only goes on until the end of this year, it is likely that that would be enough to push the S&P index considerably above its current levels.
It used to be said that the role of the Fed was to take the punch bowl away before the party got started. Yellen’s speech was the verbal equivalent of pouring tequila shots. If that interpretation is correct, then the party on Wall Street won’t be ending any time soon.