On Wednesday, Federal Reserve Board Chairman Ben Bernanke announced the first reduction, or “tapering,” in the Fed’s monthly security purchase plan, known as “quantitative easing.” Wall Street has forecasted that the cutback will amount to $10 billion out of the Fed’s current $85 billion Treasury and mortgage-backed security purchase per month.
Many are confused about what exactly “quantitative easing” is, despite the centrality of the program in the nation’s fiscal policy. An ongoing Reuters/Ipsos poll has indicated that only 27 percent of all respondents knew — from a list of five possible choices — what “quantitative easing” is. 12 percent of all respondents thought QE was a computer-assisted program that the Fed used to manipulate the dollar. 11 percent thought it was part of the Dodd-Frank Wall Street reform legislation.
While QE represents a level of government intervention that is little-talked about and hard to explain in ordinary conversation, it is for the most part the government’s main tool in its recovery efforts from the ramifications of the Great Recession that began in 2008. While it’s debatable among economists if the public really needs to know how QE works to benefit from it, knowledge, as they say, is power. So let’s take a moment to break down what “quantitative easing” really is.
“Quantitative easing” 101
To understand what exactly “quantitative easing” is, it is important to understand what exactly the Federal Reserve does. The Federal Reserve System is the nation’s central bank, serving as the formulator and executor of the nation’s monetary policy. The Fed monitors and regulates the member banks of the system and those banks’ holding companies, controls international monetary policies in which the United States or a U.S.-based institution is a partner, influences the nation’s payments and collections systems, limits the amount of currency in circulation and establishes margin requirements for the purchasing and carrying of securities.
This is all to help the Fed meet its two mandates. First, the Fed is meant to institute policies that minimize unemployment to an “acceptable” level, which is historically held at between 5 and 6.5 percent. To do so, the Fed works to implement policies that encourage business growth, create jobs and promote new spending. Second, the Fed is meant to maintain a stable and low rate of inflation. “Stable” is more important than “low” in this equation, as uncertainty about interest rates makes long-term forecasting impossible, collapsing growth and scaring off investors.
By law, every bank in the United States must have a reserve, or a cushion of funds-on-hand to hedge against the banks’ borrowing. If the Fed was, hypothetically, to buy bonds and Treasury instruments from a bank, that would increase the bank’s reserve — effectively, pumping cash directly into the nation’s money supply. That would give the bank leverage to accept more debt, which would increase business and — hopefully — personal lending. This in turn would lead to business expansions, more spending, more jobs and a happier economy.
This is usually accompanied by lower interest rates. A lower interest rate reduces the cost to secure lending. Lower rates mean a lower bank-to-bank lending fee and more cash-on-hand, promoting more lending. A looser lending position encourage private borrowing — which means more house mortgages and more car notes. Again, this leads to a happier economy.
The Fed’s role in this is to prevent inflation. If too much money is introduced into a system too fast, prices will increase in the presence of increased demand. This would reduce the purchasing power of the dollar and lead to long-term financial uncertainty — which the Fed attempts to avoid at all cost.
In December 2008, the Fed brought interest rates all the way down to 0.5 percent to help to spur lending after the mortgage bubble burst. When zero interest rate policy (ZIRP) failed to create an effect on the market beyond short-term interest rates, the Fed became “creative.” Inspired by the administration of former President John F. Kennedy, the Fed instituted “quantitative easing” or large-scale asset purchases (LSAPs) — which allowed the Fed to buy the banks’ mortgage-backed securities and long-term Treasury notes.
This did three things. First, it reduced banks’ mortgage-based risk, partially stabilizing banks’ investment portfolios. Second, it expanded banks’ leverage, allowing banks the freedom to engage in more lending. Finally, it reduced the number of long-term securities on the market, increasing the prices of long-term financial instruments.
Artificial inflation and the wealth gap
This artificial manipulation has been the reason why the stock market has been spiking in recent months. As the Fed continues to buy bonds, bank lending increases, interest rates stay low and long-term security prices remain at a high level. With security prices artificially high, investors are increasingly motivated to buy stocks, causing trading volume to increase and stock prices to rise.
The problem, however, comes in the realization that banks are only lending to businesses. Personal lending, for the most part, is still frozen, with only a small fraction of banks indicating a relaxation on loan standards at the end of 2012. Meanwhile, banks’ profits during the fourth quarter of 2012 hit $34.7 billion — a 37 percent jump from the same quarter in 2011. This more than any other factor has contributed to the widening income gap between the wealthiest Americans and the middle class during the recovery from the Great Recession.
The Fed currently holds about $1.7 trillion in securities, collected from three phases of QE, the current one of which being announced September 13, 2012 to effectively relieve $40 billion per month of commercial housing market debt risk. With Bernanke’s time as head of the Fed slowly running out, the “tapering” of the QE — or the slow reduction of security purchases — not only reflects Bernanke’s faith that the economy is starting to recover, but Bernanke’s insecurity about who will replace him. While forerunner Fed Vice Chairwoman Janet Yellen — a longtime Bernanke supporter — would likely continue QE, other candidates — such as former vice chairman of the Fed’s Board of Governors Don Kohn — may see the excessiveness of the Fed’s balance sheet as a cause for concern and trigger a sell-off, which would spike interest rates and cut lending.
What this all comes down to is a simple thought: the Fed is ran by humans — humans concerned about their political mortality and who have differing opinions, priorities and perspectives. As the drama of who will replace Bernanke unfolds, there is a rush to get everything that must be done completed before time runs out.
In a way, the Fed is no different than any other agency in Washington. All that can really be hoped for is that the people’s will be done in the midst of all of the bluster and noise.
“When they sit down at the massive mahogany table in that marble building on Constitution Avenue,” said Morgan Stanley chief U.S. economist of the FOMC Vincent Reinhart on introducing the QE taper, “they will tell themselves that forward–looking indicators suggest ongoing momentum to activity, financial conditions remain accommodative, and markets are receptive to risktaking. If not now, when?”
Public “fuzziness”
The Ipsos/Reuter poll reflected the current communication problem the Fed has with the American people. For an agency that has stressed transparency with the public, the idea that three-quarters of the American people are so confused by one of the Fed’s biggest programs represents a failure in the bank’s outreach. The Fed has worked to assure a cautious public that its maneuvering of the bond-purchase program would not affect interest rates in a significant way. Unfortunately, the well-telegraphed indication of a buyback reduction completely went over the public’s head, while sparking the security markets to start raising rates in anticipation of the Fed’s move.
“I think they understand the Fed is trying to stimulate the economy, but I don’t think they understand the mechanics of how it works,” said Scott Anderson, chief economist at Bank of the West. That means, he said, “People get the message that interest rates are going up.”
Some economists feel that general public’s understanding of the program is irrelevant, arguing that it’s the program’s results that really matter. “The beliefs of the general public … isn’t the primary channel that the Fed has been relying upon,” said Michael Woodford, a Columbia University professor and leading expert on QE. Woodford argues that it is more important that bond traders understand the program and particularly the Fed’s intention behind it. If the traders were to drive down interest rates in response to the buyback reduction, those lowered rates could spur spending.
However, other economists feel that a fuzzy understanding of fiscal policy should not be enough for the public. “When making investments, or taking out a loan, it’s terribly important that we understand how the decisions taken in Washington affect us,” said Carl Tannenbaum, Northern Trust’s chief economist. “The Fed at times has not done a very good job of explaining what it is up to. It’s also fair to say that the state of financial literacy in the United States offers important room for improvement.”