Quantitative easing involves large scale purchases of assets by a central bank that are meant to stabilize rates, stimulate lending, and bolster the economy. This type of monetary policy is typically used when inflation and output are below their targets and interest rates are already near their lower bound.
The U.S. has implemented quantitative easing several times since the financial crisis of 2007 – 2008. Most recently, during the pandemic in 2020. Currently, the Fed has begun reducing asset purchases in a process called tapering. To determine how tapering may impact the current economy, it’s important to understand the history of quantitative easing in the U.S. and how those programs impacted markets.
Quantitative Easing in the US
Quantitative easing occurs when the Fed purchases large quantities of assets, typically Treasury and mortgage-backed securities. In order to do this, the Fed creates new bank reserves. The Fed then buys securities from major financial institutions with the newly created funds, increasing cash and lending ability at the nation’s banks.
When the Fed buys assets, interest rates usually decline due to higher demand for the securities being purchased. Lower interest rates encourage individuals and businesses to take out loans. Additionally, when bond interest rates are low, investors often turn to equities to bolster their investment returns. This can lead to larger stock market gains.
The U.S. has implemented quantitative easing four times. (*Link to history of QE article*) The first was in November 2008 in response to the global financial crisis. Between November 2010 and June 2011, the Fed purchased additional long-term Treasuries in the second round of QE. The third round of QE, which began in September 2012, was different than the previous two iterations because the Fed did not specify a total purchase amount or timeline for the conclusion of the program.
The most recent round of QE began in March 2020 in response to the COVID-19 pandemic. This round of quantitative easing was similar to the 2012 program. In both instances, the Fed purchased mortgage-backed securities and Treasuries and did not specify a timeline for purchases.
Economic Effects of Tapering Asset Purchases
The first two iterations of QE were for pre-announced totals so there was less of an immediate impact on markets when the purchases were slowed. The third round of quantitative easing, which began in 2012, was open-ended. When tapering was announced, the stock and bond markets reacted negatively.
Taper Tantrum 2013
May 22, 2013 Fed Chair Ben Bernanke discussed tapering asset purchases in the near future. Markets reacted swiftly, with the 10-year Treasury yield growing from 1.94% on May 21 to 2.03% on May 22. After more tapering discussions, but no action taken by the FOMC, yields jumped to 2.96% by September 10.
Not only did bond yields rise, stock prices fell. When the risk-free rate rose, it hurt stocks that rely on the discounted cash flow model to derive their value. The Dow fell each time that the Fed discussed tapering– losing 4.9% in May and June and 5.6% in August.
The Fed began tapering purchases in December 2013 and the 10-year Treasury yield rose slightly, reaching 3.04% by the end of the year. Additionally, interest rates for conforming mortgages rose and new loan originations fell by about 30%. Tapering lasted through October 2014 when the asset purchase plan ended. By that time, 10-year treasury yields had fallen back under 2.5%.
In July 2021, the FOMC began discussing tapering. Throughout the course of the fourth round of quantitative easing, FOMC members have said that the purchases will continue “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Despite worries that that taper tantrum of 2013 would repeat itself, the Treasury yield remained around 1.3% after the taper discussions.
Discussions continued throughout the summer and fall. Some economists anticipated a taper decision in September but the FOMC delayed. Between the September and November meetings, the 10-year Treasury yield rose around a quarter of a percent. At November’s meeting, FOMC members announced a tapering plan that would conclude by the middle of next year and involve monthly reductions of $10 billion of Treasuries and $5 billion of mortgage-backed securities. The 10-year Treasury yield remained steady, hovering around 1.6% where it has remained.
The commonality between the 2012-2013 and 2020-2021 QE programs is that they were open ended monthly purchases. However, markets have not reacted as negatively to tapering in 2021. One explanation is that this year’s announcement was more in line with expectations while the 2013 tapering announcement was viewed by some as premature. Even though markets avoided a tantrum when tapering was announced, there are certain economic repercussions that can be expected when quantitative easing ends.
What to Expect from the Economy During Fed Tapering?
FOMC members continue to believe that, “The path of the economy continues to depend on the course of the virus.” The impact of tapering will likely be moderate based on how the market has responded so far. However, if rates rise significantly, it could put pressure on growth stocks and the mortgage market.
Interest Rates May Increase
When the Fed reduces purchases through tapering, it removes itself as a buyer of Treasury and mortgage-backed securities. As a result, yields for these securities may increase due to a smaller pool of buyers. If this occurs, loan interest rates are likely to follow.
However, rate increases are likely to be mild in the short term because the Fed funds rate is still near its lower bound. Additionally, FOMC members have indicated that they will keep rates low into 2022.
Stocks Could See Slower Growth
If interest rates do increase during tapering, this can lead to lower stock valuations. This occurs for a variety of reasons. First, valuations may dip if the risk-free rate increases. This can particularly effect growth stocks who rely on a discounted cash flow model to derive their value.
Secondly, investors may move some of their assets away from riskier assets if bonds yields become more attractive. In general, when yields rise, investors tend to move some of their assets from the stock market to the new higher paying bonds.
Finally, higher interest rates can lead to higher cost of debt for both businesses and consumers. For businesses, this can mean that expansionary activities become less attractive due to higher cost of borrowing. For the overall economy, consumption may decrease if the cost of consumers’ debt takes up more of their budget.
Inflation May Slow
Quantitative easing increases the supply of money in the economy and can lead to or exacerbate inflation. Decreasing asset purchases slows the influx of new cash into the market. Theoretically, this could lead to reduced inflation. However, the Fed will likely maintain the assets that they have purchased during the latest round of quantitative easing, leaving the money supply higher than before the pandemic.
Additionally, the effect of tapering on inflation is likely to be mitigated by the current factors that are leading to high inflation. The current inflationary environment is heavily influenced by pandemic-related supply chain bottlenecks and labor shortages. Tapering on its own is unlikely to ease these issues.
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