The Fed's QE Confession

By Joseph Calhoun

A couple of days ago the Federal Reserve Bank of San Francisco released a report on the effects of Large Scale Asset Purchases, commonly known as Quantitative Easing. Their conclusions are a bit underwhelming:

In November 2010, the Fed's policy committee, the Federal Open Market Committee (FOMC), announced a program to purchase $600 billion of long-term Treasury securities, the second of a series of large-scale asset purchases (LSAPs). The program's goal was to boost economic growth and put inflation at levels more consistent with the Fed's maximum employment and price stability mandate. In Chen, Cúrdia, and Ferrero (2012), we estimate that the second LSAP program, known as QE2, added about 0.13 percentage point to real GDP growth in late 2010 and 0.03 percentage point to inflation.

Our analysis suggests that forward guidance is essential for quantitative easing to be effective. Without forward guidance, QE2 would have added only 0.04 percentage point to GDP growth and 0.02 to inflation. Under conventional monetary policy, higher economic growth and inflation would usually lead the Fed to raise interest rates, offsetting the effects of LSAPs. Forward guidance during QE2 mitigated that factor by making it clear that the federal funds rate was not likely to increase.

That 0.13% is the effect at the time the program is initiated and the effects wane over time, assuming this model used by the Fed is more accurate than all the other ones they seem to be using. Color me skeptical but hey, I'll give them the benefit of the doubt. No matter how you slice it, the effects of QE on the real economy are almost negligible. I have believed from the beginning that the effect of lower interest rates would be greater on the economy and while they don't address that specifically they do say:

Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy.

Interest rates and rate expectations probably also have a larger impact on stock prices than QE itself although it is impossible to know how many bulls are buying stocks based on QE good, buy stocks. Certainly there are a lot of them and stock prices are probably higher than they would have been without QE. But low rates forever does directly impact stock prices through the discount rate effect. The lower the discount rate - and the longer it is expected to stay low - the higher the multiple that can be justified for the stock market, assuming of course that earnings don't collapse. And that is largely what has happened as the market has moved from roughly 14 times earnings to 18 times earnings. So what will happen to stocks when QE is tapered or even worse, when it ends?

This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

Well, I'm sure that is what the Fed wants to believe and they may be right about the effect on the economy. If QE didn't raise growth that much it surely won't hurt it much when it ends. As for stocks, well that depends on how many people have bought thinking QE was having a big impact. If that is a large cohort - and I think it probably is - then I would expect a lot of them to sell when it ends. I doubt most of them are reading the SF Fed's research papers.

So, QE, what is it good for? Not much apparently. The natural question then is why has the Fed pursued it so aggressively? My guess is that it has a lot more to do with bank earnings and the Fed's desire to recapitalize the banking system than any effect on the economy in real time. I guess that could help growth at some point in the future, but that assumes the banks aren't doing something really stupid right now. Based on history that probably isn't a good assumption.

Joseph Calhoun is CEO of Alhambra Investment Partners in Miami, Florida. He can be reached at jyc3@alhambrapartners.com

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