At long last, it’s here: On Wednesday, the Federal Reserve is expected to announce the end of its stimulative bond-buying program, known as quantitative easing.
Or at least that’s what a lot of headlines will read. Technically, the program won’t be ending because the Federal Reserve will still keep on its books the trillions of dollars of longer-term government debt and mortgage bonds that it has bought since the first round of QE in 2008. And the Federal Reserve argues that keeping these bonds off the market will continue to have stimulative effects.
Federal Reserve officials have made it clear that its cessation of bond buying hinges on the continuing improvement of the U.S. economy. If things get worse, the Fed assures us, they won’t hesitate to start bond buying once again. But the conventional wisdom is that, even if the economy isn’t a strong as we’d like, it’s strong enough to no longer need the Fed to continue to pile on support, and that we’re beginning the process of returning to something that looks more like pre-crisis Fed policy.
It would be nice if market participants could actually agree on what all these years of bond buying has done for the economy. But they can’t. So it’s not surprise that why no one can agree on what the end of QE will actually mean for the markets or the economy.
Take, for instance, the disconnect between the Federal Reserve’s own predictions for inflation and the future path of interest rates and what the bond markets think will happen. As Jim O’Sullivan, chief U.S. economist at High Frequency Economics, points out in a recent note to clients, the bond market is predicting that inflation will continue to fall below the Fed’s goals and that interest rates will be 150 basis points below what the Fed is hoping for by the end of 2015.
O’Sullivan thinks that the difference can be summed as a disagreement between the Fed and the bond market over how well the economy will be doing a year from now. The Fed is more optimistic than the bond market when it comes to employment and inflation, and something, eventually “will have to give,” he writes. “We expect bond yields to rise as market expectations for Fed policy adjust.” Even a scenario in which the Fed ends up “lowering their projections somewhat,” Sullivan argues, “would entail higher bond yields.”
But others point out that the Fed has been consistently overoptimistic in recent years, so why should we expect anything different next year? Jim Bianco, president of Bianco Research, points to recent comments by St. Louis Federal Reserve Bank President James Bullard that declining inflation expectations suggest that the central bank should hold off ending QE altogether. Bullard’s about-face on QE, which just a few months ago he was certain would end this fall, is evidence of the Fed’s unmerited optimism. As Bianco said last week in a conference call with clients:
I have argued and will continue to argue that the Fed is going to get out of QE on the October 28th meeting. They’re going to taper $15 billion and they’re done. If you ask the Fed whether they are done with QE forever, they will tell you, “Yes.” If you put them under truth serum and ask them that, they would still tell you, “Yes.” As was the case after QE1 and after QE2, they were dead serious—“We’re done. This experiment is done forever.”
Then, we had a 17% correction in stocks after QE1 ended and the Fed freaked out and gave us more money printing to stop it (QE2). When QE2 ended stocks had a 20% correction and again the Fed freaked out and gave us Operation Twist. This eventually morphed into more money printing.
In other words, the Fed said it was done before, but that’s only because it was too optimistic about the future health of the economy. So the central bank may end QE tomorrow, but the chances that the Fed will rev up its bond-buying machine in the near future are significant.
Bianco believes the main goal of QE is to prop up the stock market with the hope that an expensive stock market will give people the confidence to spend. Fed officials would probably argue that higher asset prices are merely a second-order effect of their policy and that they are primarily trying to lower interest rates in an effort to get businesses to invest. But either way, the policy requires growth in demand to organically materialize within the economy so that there are people and firms willing to invest at these new low interest rates.
And it’s this last part that really hasn’t come to fruition. Job gains continue to accelerate, but wage growth is flat. Economic growth in 2014 might end up a tick above last year, but it’s still far below what you would normally see in a recovery. To believe Wednesday will truly mark the beginning of the end of Fed stimulus, you’d have to believe that we are in the beginning stages of a legitimately robust recovery. There’s some evidence to support this notion, but don’t expect the jury to return with a decision anytime soon.