Monetary Policy and the Ending of QE3

Before the 2008 financial crisis, central bankers were primarily concerned with maintaining a low and stable rate of inflation through adjusting short-term interest rates. An increase would discourage borrowing, holding inflation stable, while lowering the rate would spur growth and employment. Economists were so confident in the use of this technique that they had declared a time of “Great Moderation” because of decreased macroeconomic volatility. The crash of the stock market in 2008 effectively ended the Great Moderation, undermining central bankers and their method of sustaining growth. Since then, monetary policy has been in turmoil, with the Federal Reserve drawing criticism from politicians and academics alike. Under conventional monetary policy, the Fed buys and sells short-term U.S. debt, which effectively lets it control short-term interest rates. However, short-term rates have been near zero since 2008 and cannot be lowered further. Because the economy has not responded to traditional policy, the Fed must resort to unconventional measures such as quantitative easing by buying longer-term bonds.

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            In general, the central bank purchases financial assets from commercial banks and private institutions. During the first round of QE, the Fed attempted to revive the housing market through purchases of mortgage-backed securities and treasury bonds. Additional rounds followed in 2010 and 2012 as a result of poor growth. Under QE3, the Fed would buy $40 billion of MBS per month in addition to $45 billion of Treasury securities and keep short-term rates near zero until at least 2015. It would continue to buy bonds until the economy was deemed to have sufficiently recovered. This increases the prices of those assets, lowering their yield, and increases the monetary base. These effects’ similarities to those of printing money has been the primary concern of economists and politicians who argue that the Fed is debasing the dollar and leaving the economy vulnerable to runaway inflation. Contrary to the latter, the data shows that inflation has remained low even after QE3 was implemented. One explanation is that consumers are cutting back on spending because wages are not rising. Without any increases in income, spending more money in one category means consumers have to cut back somewhere else.

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            A low inflation rate sounds like good news because we often associate inflation with higher costs and reduced purchasing power. However, long periods of near-zero inflation may lead to a larger problem- deflation. As the price level falls, consumers stop spending because they wait for things to get cheaper, further dampening growth. This is exactly the problem that the European Central Bank faces today. Mario Draghi, president of the ECB, recently announced that the central bank would pursue an asset-purchasing program similar to QE to spur growth and increase inflation to its target level of 2 percent. This contrasts recent developments in U.S. monetary policy, which is actually winding down the QE program.

            Last September’s announcement that the Fed would begin to “taper,” or reduce its purchases of long-term assets was met with some skepticism despite the controversial nature of QE. Last Wednesday, the Federal Open Market Committee (FOMC) released the minutes from its June meeting, announcing the end of QE3 two months earlier than expected. Under the new plan, the Fed will continue to reduce its bond purchases by $10 billion each month until October, ending the program with a final $15 billion reduction. Some economists, such as James Bullard, president of the St. Louis Fed, believe tapering should have waited until inflation numbers were higher. Others believe that tapering is essentially a tightening of monetary policy and that inflation numbers will fall even further as a result, increasing the risk of deflation.  Despite these concerns, there are still reasons the Fed would prefer to end QE. One may be the belief that these purchases are ineffective in stimulating growth. This belief is evidenced in the inflation numbers, and further data show that the most effective policy is in fact orthodox monetary policy, keeping short-term interest rates low.

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            Since that announcement, expectations of an increase in short-term interest rates rose sharply and will likely become reality next year. In effect, the Fed has already tightened monetary policy in its discussion of tapering. However, this is what some economists want. They believe that we are close to full employment and that continuing to purchase bonds at our current rate will eventually lead to “overheating” of the economy. In addition, unemployment has dropped to among its lowest levels at 6.1 percent in June. These reasons seem to justify the belief that the U.S. recovery has reached its peak and thus no longer needs further stimulus.

            A closer look at the numbers would suggest otherwise. First of all, the unemployment rate is misleading. Unemployment has not fallen because additional jobs were created. It has come down because a smaller percentage of workers are participating in the labor force, which includes those currently working and those actively seeking jobs. When discouraged workers re-enter the labor force as the economy continues to recover, unemployment will increase again.

            Do the benefits of ending QE3 outweigh the risks? If the Fed were to continue purchasing bonds and the economy was closer to full employment than expected, inflation would rise. With inflation lower than the 2 percent target rate and many economists seeking a higher target, it seems like the costs of maintaining QE3 is low. Olivier Blanchard, chief economist at the IMF, is one such economist who believes the rate of inflation should be set around 4 percent. The Fisher Effect shows the relationship between inflation and interest rates. Higher average inflation and consequently higher nominal interest rates, would give monetary policy more flexibility while the net costs of inflation at 4 percent is not much higher than at 2 percent.

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            The effects of QE3 can be illustrated using the IS-LM/AD-AS model, focusing specifically on the LM and aggregate demand curves. When the Fed purchases bonds, money supply increases, shifting the LM curve to the right. Expected inflation causes demand for money to fall, also causing a rightward shift of the LM curve. As a result, the AD curve shifts to the right. These shifts illustrate increases in output and employment, which is desired. On the other hand, if the Fed had tightened too early, an already weak recovery could be set back further and lead to additional job losses.

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            With an end-date for bond purchases already set, Chairwoman Janet Yellen also faces difficult decisions regarding the timing and pacing of interest-rate increases. The central bank has not indicated that rates are going up soon, an encouraging sign for investors who tend to buy stocks when rates are low.

            When the Fed eventually decides to increase rates, the task will be more difficult than usual because of the influx of money in the financial system, which puts downward pressure on rates. Officials also are carefully trying to manage the public’s expectations about the timing of the rate increase. After years of assuring investors that rates would remain near zero, officials are expressing more uncertainty about how long they will stay low.

            According to the FOMC minutes, Fed policy decisions would

“depend on its ongoing assessment across a range of indicators of economic activity, labor market conditions, inflation and inflation expectations, and financial market developments…..Favorable financial conditions appeared to be supporting economic activity…However, participants also discussed whether some recent trends in financial markets might suggest that investors were not appropriately taking account of risks in their investment decisions….Volatility in stock, bond and currency markets has been unusually low in recent months. That could be a sign ‘market participants’ were not factoring in sufficient uncertainty about the path of the economy and monetary policy”

            Because the ending of QE3 indicates the Fed’s belief in the economic recovery, there is increasing concern over investors’ risk taking habits, where excessive risk could lead to bubbles in the market. Chairwoman Yellen addressed these concerns in front of Congress on July 15th during her monetary policy testimony. She believes that markets are in reasonable health despite signs of bubbles in areas such as social media and technology companies. In her testimony, she focused on unemployment and inflation, stating that the economic recovery remained incomplete and still required further stimulus from the Fed. Yellen agrees that the unemployment rate of 6.1 percent is overstating the progress of the recovery but expects the number to fall towards its “sustainable level.”

            What will be most interesting to watch for in the future is the concurrent progression of both the U.S. and global economy, specifically in Eurozone countries. Both economies are experiencing the same difficulties- stagnant growth that includes low output and low inflation. However, U.S. officials have continued to express confidence in the recovery and are beginning to ease up on the stimulus effort. The ECB is doing the opposite in adopting a bond purchasing program, but has been reluctant to resort to quantitative easing outright. With QE3 coming to an end, the focus turns to expectations of future interest rates, which will play a large role in future developments.