The Federal Reserve lowered interest rates again last week, for a third time this year, and that got the headlines. But beyond the headlines there’s an argument taking place on Wall Street (and in Washington) over whether another tool in the Fed’s arsenal—quantitative easing—could help keep the economy expanding into an eleventh year, which also happens to be an election year.
“Quantitative easing is an unconventional monetary policy tool used after conventional tools have become ineffective,” says Nancy Davis, Portfolio Manager of the IVOL ETF and Founder of Quadratic Capital. The unconventional tool helped get us out of the Great Recession, but 2019 is not 2008, and there are many who believe QE is no longer a magic elixir.
That doesn’t include President Trump, who has repeatedly called on the Fed to lower interest rates, including in the spring, when he also pushed for the Fed to employ quantitative easing in order to give the economy and stock market a boost. In an April 5th tweet he said, “You would see a rocket ship.” And that was after a first quarter GDP of 3.1%. Last week’s GDP print of 1.9% compelled him to return to the topic of lower rates again, calling out Fed Chief Jerome Powell for not keeping pace with other countries in lowering their key rates.
There was a time when quantitative easing by the Federal Reserve was like the cavalry riding in to save the day. Then-Fed Chief Ben Bernanke, a student of Great Depression, utilized the approach to add liquidity and reserves to the financial system when it looked like the banking industry was on the verge of collapse in 2008. Nancy Davis explains how QE works. “The Fed buys specified amounts of financial assets, thus raising the prices of those financial assets and lowering their yields.”
Specifically, the Fed bought Mortgage-backed securities—at a time when many institutions wouldn’t touch them—as well as Treasury notes and bonds. Collectively, these actions made sure that financial institutions wouldn’t be left with worthless debt instruments (like some of the MBS’s). It pushed down interest rates across the board with such large (“quantitative'”) actions, making borrowing cheaper for consumers and businesses alike (that’s the “easing” part). “The idea,” says Davis, “is that individuals and corporations could borrow money cheaply for a long time, stimulating the economy.”
By 2014, following three rounds of QE, the Fed’s balance sheet was approaching $4.5 trillion, compared to a pre-financial crisis balance sheet in 2006 of less than $900 billion. The approach had worked. But how do you undo quantitative easing? By shrinking the Fed’s balance sheet.
In 2017, under the guidance of Chair Janet Yellin, the Fed started to “normalize” its balance sheet by not reinvesting the proceeds (money) when the debt securities matured. Without the Fed as a customer in the financial markets, issuers had to raise yields and lower prices to be competitive. Fortunately the effects on interest rates have been modest because the normalization has occurred over a number of years (until a recent blip, which we’ll address in a moment). The return to “normal” allows the Fed to use QE again in the future if conditions call for it. The debate continues over what those qualifying conditions are.
Will QE stimulate growth?
Many on Wall Street don’t believe that another round of QE—or even continuing to lower the Fed Funds rate directly—will stimulate more growth. Ryan Severino, Chief Economist at JLL, puts it this way: “You can’t say we’re in the best economy we’ve ever seen but we need quantitative easing to improve our situation.” Severino believes that lower interest rates are not the issue with tepid economic growth. “Investment by businesses fell in the 2nd quarter. The things that are holding them back are policy uncertainties, including trade uncertainties—not interest rates.” And he worries that when the next recession comes, QE will be less effective. “We’d be using a lot of our monetary artillery where it won’t have a lot of impact.”
The QE argument also reared its head last month when the Fed had to infuse the financial system with cash when there was a shortage of liquidity for member banks in overnight transactions. The momentary spike in rates, and the entry of the Fed to calm the markets down, led Chairman Powell to announce that the Fed will be buying $60 billion of short term debt each month. To a lot of people that sounds like quantitative easing.
Nancy Davis says it’s not QE because the Fed will be buying short term, not long term, debt. “In reality, those purchases should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.”
Another round of QE might not have much of an effect anyway. Business surveys show that CEO’s are less interested in lower interest rates and more interested in a clear direction on trade policy because of how it affects the economy and business investment. “If companies become too pessimistic,” says Severino, “it’ll eventually spill over into hiring and wage increases. That could affect the consumer.”
Several years of tepid GDP growth proves that the formula for growing the economy is not always as simple as lowering interest rates. “But if the only tool you have is a hammer,” says Severino, quoting Maslow, “then everything looks like a nail.”
QE may qualify as a monetary hammer, but today’s moderately growing economy is not necessarily a nail. It just looks like one to some people.
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