Since 2007/2008 crisis Fed made several steps towards improving and stimulating our economy. One of the most well-known and frequently heard (in media) strategies is Quantitative Easing (QE). It`s frequently heard but not a frequently used open market operation, this is only third time Fed had to use QE to foster its goals to stimulate high employment and to keep inflation and long-term rates within the range.
So, what is this QE and how it works. In the late 2012, Fed announced that it would buy mortgage-backed and long-term treasury securities for $85 billion every month. This purchases reduces the supply of those securities which drives their prices up and yields down. Lower yield is important for two reasons: 1. The lower the yield is, the lower the mortgage rates are, which means more affordable housing for population. 2. Lower yield encourages investors to find the securities with higher yields which usually are corporate bonds or other privately issued securities. Thus, QE caused downward pressure on yields across the board because high demand will cause higher prices and lower yields for private securities as well. As a result Fed can reach its goal to keep long-term rates lower and stimulate economy.
Their objection is that lower yields result into lower cost which on its own is supposed to increase expenditure and the latter contributes to GDP and economic growth. Spurring spending usually leads to a lot more hiring and investment increases.
Another strategy is to keep a short-term interest rate=federal fund rate low. Currently Fed keeps its fund rate near zero to improve unemployment rate. The idea behind it is that if the short-term rates are lower, then banks and corporate world has more funds available at lower cost to invest in long-term development and operations which is supposed to spur our employment and economy.
The questions I have regarding these strategies are following:
How long can Fed keep short-term interest rates near zero? The interesting part about this is that we all know from the history economy does not stay on the same level for very long. At some point booming economy might collapse and Fed will need this tool again to lower its fund rates. However, it will not be able to use this strategy if it keeps the rates near zero now because rates cannot go below zero. So, what happens when Fed will have to start increasing its fund rates?
They manipulate with short-term rates to keep unemployment rate low and this QE was directly connected to the unemployment level by saying that Fed will start tapering when it sees unemployment going down. This is all understandable but I am concerned about the rate they use to measure the unemployment and this idea of labor force vs discouraged/out of labor force population. If a person is discouraged how come he/she is considered out of labor force and thus not included in unemployed people. And how well can this measurement of the employment situation show us true economic situation in the country?
And last but not least idea that surprises me is this fear of tapering. Everyone on the Wall Street is concerned that tapering will cause a drop on the market. But does not tapering happen because economy is stronger? If the economy is strong and booming why would any given investor want to find a shelter under the treasury bonds with lower returns? Especially when Fed spent months explaining that tapering does not presage an imminent raise in a short-term rate. I think we should be more concerned about when Fed is starting to raise a fund rate rather than tapering. And we saw that market did not collapse when Fed decreased its QE by ten billion in December, 2013 and another ten billion in January, 2014.
I would like to finish with a quote from Yahoo Finance article by Jon Hilsenrath, which proves my fear towards rates: “If the officials raise interest rate too soon, they risk choking off the recovery – but raising them too late could send inflation too high or fuel financial market bubbles.”