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Quantitative Easing, A Misunderstood Policy

According to the media, ending quantitative easing would pull the rug out from under stocks and the economy. This couldn’t be further from the truth.

Rarely has a policy been so misguided and misunderstood. The Fed’s $35 billion per month asset purchase scheme finds itself in the perverse situation of running the printing presses to a contractionary and deflationary effect. The media tells you ending quantitative easing (QE) would be pulling the rug out from under stocks and the economy—this couldn’t be further from the truth.

The concept behind QE is to make borrowing cheaper for business and consumers. By buying bonds, the Fed lowers long-term interest rates in the hopes of stoking loan demand. The Fed creates reserve credits—base money—and buys bonds from banks across the US. This causes bond prices to rise (supply and demand), while pushing down yields—which move inversely to prices. This creates lower long-term interest rates. Yields have moved higher since the Fed dialed QE back.

This leaves banks with two things: a lot of reserve credits (cash, for all intents and purposes) and low long-term interest rates. For this to have a stimulating effect, the banks would have to lend the money out. But here’s the kicker—low long-term rates discourage lending. Banks make money on the spread—the difference between short and long-term interest rates. Banks borrow short term (checking and savings accounts) and lend long-term (mortgages, business loans). The difference between those two is banks’ core business, loan revenue. QE has narrowed that spread, meaning banks’ profit margins have contracted. It’s highly unlikely they’re going to take on more risk for a reduced profit.

Capital is critical to growth—meaning QE is holding the economy back, not juicing it up. Ending QE likely provides more stimulus than the policy itself.

US Treasury Bond Yields as of 12/31 Year-by-Year

Chart of US Treasury Bond Yeilds

Source: Federal Bank of St. Louis.  All rate shown are constant maturity rates as of 12/31/ of each year.