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QE, Tapering and the FED

Posted by Akhilesh Ganti on Aug 20, 2013 8:50:00 PM

Quantitative Easing(QE) was implemented by the Federal Reserve(FED) to try and resuscitate the US economy after the 2008 financial contagion depressed growth and caused unemployment to skyrocket. Recently there has been a lot of chatter about rescinding or tapering this process and whether that is a viable option given the uncertain growth prospects. The FED's dual mandate of pursuing price stability and maximum employment is at the crux of this debate.

ECONOMIC GROWTH
Defined as the amount of production in a country or region over a certain period of time and is often considered to be one of the best gauges of a country’s overall economic health. In theory, an increase in production should translate into more jobs, which would increase consumption, thereby leading back to more production. One of the chief ways to measure this would be through job creation numbers. More jobs being created usually means that wealth is being created and spread.

QUANTITATIVE EASING(QE) - Mechanism
The FED or any central bank purchases bonds and other financial assets from banks and other institutions. These purchases reduce the available supply, causing prices to rise and yields to fall. Lower yields lower the cost of borrowing which should make loan procurement easier and thereby facilitate the financing of new projects. These new projects should increase employment which should result in an increase in consumption and economic growth.

Thus, the overall goal is to put downward pressure on yields with the intent being that this should promote a stronger economic recovery. Essentially this is a monetary policy tool that the FED has at its disposal to stimulate the economy with the understanding that they will rescind this once the objective has been reached or if they see any emerging threats to their other mandate, price stability.

QE INFINITY
On September 13, 2012, the FED launched its latest round of quantitative easing and, for the first time, officially stated that they would keep short term rates low through 2015 as they did not believe that the economy could keep growing without stimulus. They came up with a plan - QE Infinity - where they would purchase $85 billion of fixed-income securities per month - $40 billion of mortgage-backed securities and $45 billion of US Treasuries. Unlike QE1 and QE2, this program has no pre-set end date.

To Taper or not to Taper
The question of removing the stimulus came about when Chairman Bernanke stated in his late May testimony before Congress that the Fed may taper asset purchases in the coming months. If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases. He hinted that they may begin to taper QE before the end of 2013, with the program ending entirely in 2014. This, in and of itself, should not have come as a shock to the market as QE was never intended to last forever, but the lukewarm economic data, especially the employment report, led many to question the wisdom of such a move at this juncture.

The subsequent market turmoil and the sharp spike in yields forced him to amend his statement a bit a few weeks later when he emphatically stressed that the process was solely dependant on incoming economic data. Weak growth would see a continuation QE Infinity, while improved growth and/or rising inflation, which is not an issue currently, would precipitate a taper.

FOMC MINUTES - Expectations
Which brings us to the reason why today's FOMC minutes are so eagerly anticipated. The market wants some insight into the FED's thought process, specifically the level of support, if any, for a September start to the tapering process. Aside from the fact that it's roughly 1 year since QE Infinity was launched, it would indicate that the FED believes that the US economy is structurally sound enough to stand on its own. Conversely, if the committee were to echo Bernankes' July 10, 2013 statements, then the market would conclude that economic growth is still fragile and in need of the current level of stimulus. The former should be bullish for the US Dollar and yields while the latter would be viewed in a bearish vein.

Either way, expect volatility !

 

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