Blog | Personal Finance

To QE or Not To QE That Is The Question

meet your own rich dad - start your quiz now

Quantitative Easing (or QE) has been very successful in reflating the US economy. In fact, it is the reason the United States is not in a severe recession now. Because of QE interest rates are very low, property prices are moving up (and moving up sharply in some locations) and the stock market has risen 15% since December, when the Fed announced it intended to double the size of QE 3 to $85 billion a month. Rising asset prices have caused “Household Net Worth” to return to its pre-crisis high, creating a Wealth Effect that drives economic expansion by fuelling consumption.

The problem, of course, is that when QE ends, interest rates will rise, property prices will fall, the stock market will tumble, Net Worth will shrink and the economy will go back into recession. So, what’s the Fed to do?

Fed Chairman Bernanke testified before the Joint Economic Committee of Congress on May 22nd. In response to a question from Congressman Kevin Brady, he said it is possible the Fed could soon begin to reduce the amount of money it creates each month, but that the decision would depend on the incoming economic data. Those words caused the Dow to fall 228 points by the end of the day.

The market’s fall was an overreaction. Most of Bernanke’s testimony suggested that QE was likely to continue at its current pace for some time to come. Still, the sharp selloff in the stock market gives a very clear indication of what will happen when the Fed does begin to slow down the speed of its printing presses.

Quantitative Easing is the most important factor determining the rate of economic growth and the direction of asset prices in the United States and globally. Therefore, it is crucial for investors to try to understand how the Fed sees the world in order to anticipate when it may adjust its money-printing policies.

The Fed has a dual mandate: to support employment and to ensure price stability. In his opening remarks to Congress last week, Bernanke stated that “the job market remains weak overall” and that, “consumer price inflation has been low.” The unemployment rate is 7.5% and the underemployment rate is 13.9%. The price index for personal consumption expenditure rose only 1% over the 12 months ending in March. That is at the low end of the Fed’s preferred range of 1% to 2%. Moreover, the trend is downward.

Bernanke also pointed out that Europe’s severe recession was damaging US exports and growth. Finally, he said fiscal austerity in the US was a drag on the economy, citing a Congressional Budget Office estimate “that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1.5 percentage points during 2013, relative to what it would have been otherwise.”

In other words, the Fed believes QE is necessary and that it is working. Bernanke said, “In the current economic environment, monetary policy is providing significant benefits. Low real interest rates have helped support spending on durable goods, such as automobiles, and also contributed significantly to the recovery in housing sales, construction, and prices. Higher prices of houses and other assets, in turn, have increased household wealth and consumer confidence, spurring consumer spending and contributing to gains in production and employment. Importantly, accommodative monetary policy has also helped to offset incipient deflationary pressures and kept inflation from falling even further below the Committee’s 2 percent longer-run objective.”

And, he emphasized that “at its most recent meeting, the (FOMC) Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.”

The one really serious concern the Fed Chairman expressed about QE was “the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors …. may reach for yield by taking on more credit risk, duration risk, or leverage.”

And here, of course, is the rub. The effect that massive fiat money creation has on economic stability is akin to that which cocaine has on someone suffering manic-depression. It causes short-term euphoria followed by a debilitating crash.

For now, the Fed intends to continue administering the stimulus. If the patient becomes too manic (for instance, if the stock market boom threatens to get out of control), the dosage may be reduced; but it won’t be stopped cold turkey. On the other hand, if the patient becomes to lethargic (and inflation threatens to become deflation), the dosage could well be increased.

That’s how things stand. The economy is sick. Fiscal policy is making it sicker. So, the Fed is feeding it uppers. Getting the dosage just right will be no easy task. Meanwhile, the stock market’s mood swings can be expected to become more frequent and more extreme.

Original publish date: June 03, 2013

Recent Posts

Three Investment Values
Personal Finance

The Rich Dad Guide to Investing Values: Defining Your Path to Financial Success

It’s important to know which core values are most important to you, especially when it comes to the subject of money and financial planning.

Read the full post
Risky vs. Safe Investments
Paper Assets

Smart Investing: Understanding the Difference Between Risky and Safe Options

What you may think is a “safe” investment, I may see as risky. For example, many financial planners advise their clients to get into so-called “safe” investments — such as savings plans, mutual funds and 401(k)s.

Read the full post
Mastering Money
Paper Assets, Personal Finance

Mastering Money: The Key to Achieving Financial Freedom

Begin the path to making money work for you today, not the other way around.

Read the full post