For nearly 10 years, the financial media has been covering the Federal Reserve’s actions regarding quantitative easing. You’ve no doubt heard phrases such as, “easy money policy,” “QE2” or “stimulus measures.” Just recently the Fed announced that they will begin reversing quantitative easing. If you’re not a bank, what does this all mean?
First let’s look at quantitative easing: It is an alternative tactic the Federal Reserve employed to manage the financial crisis of 2007-2008. The Fed began buying long-term bonds and mortgage-backed securities. This lowered interest rates and increased money supply for the member banks. The goal is to encourage economic growth.
As of 2016, banks with more than $110.2 million in deposits are required to keep 10% of their transactional deposits in reserve to cover their checking account liabilities. This means when you deposit $1,000 in your account, the bank must hold on to 10%, or $100, and they can loan out the remaining $900. When a bank loans money, they charge interest on that loan, which of course, makes the bank more money. When the Fed bought bonds, banks ended up with increased reserves, which in turn allowed them to lend more to businesses and individuals at lower rates to further encourage borrowing. Ideally, once money is in the hands of the consumer, they will spend and stimulate the economy.
During the course of the quantitative easing measures, the Fed would take any coupon payments or money they received from maturing bonds and reinvest it into more long-term bonds. This is one of the main reasons we have experienced such a low interest rate environment for so long.
Between late 2007 and now, the Fed’s balance sheet grew from $830 billion to $4.5 trillion. It will very likely take years for the Fed to pare that down. Their first step is to stop reinvesting the coupon payments or maturing bonds. The Fed’s discontinuing the reinvestment will naturally reduce their balance sheet. Assume the proceeds from the maturing bonds vanishes from the economy. The plan for now is to patiently await the maturity of the bonds. However, if the Fed chose to step up the process, they could also begin selling the bonds, but this is not in the plan as we currently know it. If that were to occur, it could have a more pronounced impact on longer term interest rates. If any of the bonds were sold, we would expect the selling to take place among the mortgage-backed securities bought during the easing program, but again, selling is not planned for now.
These actions should result in an increase in long-term interest rates. This will be good for investors who are investing their assets for principal protection to cover liquidity needs. We likely won’t see a major jump immediately. It should be more gradual over time. If there were inflationary pressures in the market indicated by the Consumer Price Index rising, there would be more pressure on the Fed to raise interest rates whether by directly changing them or by stepping up the balance sheet unwind. This tightening of monetary policy is likely to increase the cost of borrowing for business and corporations as banks will have less to lend and will need to increase the interest rate on loans.
This is unfamiliar territory for our Federal Reserve, so we expect them to monitor the unwind of quantitative easing very closely to keep interest rates and inflation in check. Any signs of trouble would like lead to a reversal of policy beginning with lower target rates. The health of our economy is riding on their success as any disruption could topple the domestic economy into recession. We wish them well for the sake of the whole.
If you have questions regarding how the end of quantitative easing may affect your investments, the experts at Henssler Financial will be glad to help:
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- Email: experts@henssler.com
- Phone: 770-429-9166.
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