If you have ever heard talk of Quantitative Easing (QE) and “tapering,” you may have been left wondering what it is exactly. The terms are bandied about so frequently these days that it is rather difficult to parse out the facts from the political hype that surrounds every move the Federal Reserve Board, or Fed, makes.
Another, more pointed question to ask might be, “Does Quantitative Easing or tapering really even affect me?” And to answer that question you would need to know:
- What's behind the Fed's thinking
- How to interpret what the Fed says
- What a rate-hike means for the economy
- How to judge what the multitude of talking heads say whenever they report this stuff
When “Old Guy” made the comment that it might be a good idea to explain Quantitative Easing for the readers of Get Rich Slowly, I couldn't have agreed more. So this post is an attempt to explain not only what Quantitative Easing is, but also how it can affect each of us — because, esoteric though it may sound, QE is something which affects us all.
The old normal
To understand where QE came from, we first need to take another quick look at how the economy flows over the course of time.
See all those dips, or recessions? The Federal Reserve induced them.
Why? The answer lies in the mandate Congress gave the Fed back in 1913, as amended through the years. In simple terms, Congress charged the Fed with managing the economy to maintain full employment, low inflation and moderate interest rates. In order to ensure jobs for a growing population, the Fed by inference has a mandate to do its best to ensure economic growth (typically measured as GDP growth).
When the economy recovers from a recession, as it always does, it keeps growing until it reaches a point commonly called overheating. Shortages develop during this part of the economic cycle, especially labor shortages. (I know it is hard to think of labor shortages in today's economy, but it really has happened over and over again, back in the day.) Shortages typically lead to price and wage increases, something we know and experience as inflation. When this occurs, the Fed then tries to cool the economy down; and it accomplishes that by raising interest rates. Rising interest rates is what leads to recessions.
The Fed is not trying to shatter your world on purpose. Their goal is just to take the worst edge off things, but the result invariably is that another recession takes place. The holy grail for the Fed through the years has been what they call “a soft landing,” which amounts to just enough slowing down of the economy to relieve those shortages and price pressures without ending up in yet another recession.
The economy is a huge, complicated thing, though; and trying to steer it is like steering a gigantic tanker with a tiny rudder whilst navigating a current without the ability to gauge its direction or strength. At first it doesn't look like anything you do makes a difference, so you do more and more — until the tanker suddenly swings much further than you wanted.
When the economy goes into recession and people lose their jobs, the Fed attempts to stimulate the economy again by lowering interest rates and increasing the money supply.
That is how it has worked ever since the Great Depression: The Fed meets its mandate and manages the economy by making adjustments to the interest rate.
The genesis of Quantitative Easing
Given this understanding, when you look at a history of interest rates, you would expect to see them rise before a recession (to cool things down) and drop during a recession to kickstart the economy again. And sure enough, here is a chart which shows that movement (the gray, shaded areas in the chart indicate recessions):
- Fed funds rate: 1982 – Present
However, you can see that, every time, they lowered the rate more than they raised it in the next recovery.
You can see the problem that created as the financial crisis unfolded during 2007 and 2008: Basically, the Fed ran out of chart. After they lowered the Fed funds rate to effectively zero and that didn't help, the problem became what to do next.
The solution the Fed came up with was Quantitative Easing (QE).
So what is Quantitative Easing?
Cutting to the chase, Quantitative Easing involves the Fed buying government debt and mortgage bonds every month from its member banks, effectively putting money in the hands of banks to help them stay afloat and be able to lend money to businesses. Their goal was to stave off the wholesale deflation which devastated the country in the 1930s so they could prevent any more bank collapses and help turn around the economy.
The first chart above shows you that the economy has rebounded from the 2009 recession. Now the Fed believes that the need to stimulate the economy with its QE program is diminishing. Afraid of shocking the system too abruptly, they have decided to taper their monthly purchases, hoping to quietly exit the room while the kids are happily playing and won't notice, so to speak.
This chart gives you a picture of the Fed's ownership of government debt (orange line) and mortgage bonds (blue line):
- Tapering of the QE program
In the red ovals, you can see that the rate of monthly purchases is slowing down. When those purchases stop, normal repayments will lead to a gradual reduction.
But the amount of money involved is truly staggering. (That such an unprecedented infusion of cash hasn't led to hyperinflation shows how big the risk of deflation was to the economy.) Regardless of what anyone's political view on the subject of QE may be, the fact is that the Fed now is sitting on over $4 trillion of debt, a number that was unthinkable before the Great Recession.
What can we expect to happen next?
Two things: The first is that, although purchases of new bonds will wind down, that alone will not cause interest rates to rise. As some have put it: Tapering is not like hitting the brakes; it is merely one way to ease off the accelerator.
The second thing is that the Fed's management of interest rates has nowhere to go but up. So when the Fed and interest rates appear in the same sentence these days, you know what it means.
You may have noticed how the press hyperventilated about Janet Yellen's speech at the Fed's FOMC meeting last week — and how the stock market spiked when she said that the Fed wasn't going to raise rates at their next meeting in late April.
What's going on? And how does it affect you?
If you look at the second chart, you might notice how, each time the Fed hikes interest rates, the economy goes into a recession. That's what people are leery of, from the speculators of Wall Street to the employers of Main Street.
The Fed has indicated it will raise interest rates soon. How soon? That will depend on how the economy grows and where inflation and unemployment fall. In other words, the Fed will be watching the numbers and will respond accordingly. Their next meeting is toward the end of April, at which time we will hear what the next thrilling episode will be in the continuing saga, which should be titled “As The Interest Rate Turns.”
However, if you step back, you can see from the second chart that an interest rate hike leads to a recession inevitably, but not always immediately.
This is a roundabout way of saying that we are not too far from the next recession, but it might not happen this year. When it happens, though, you probably know already what to expect: layoffs, freezes, people unable to make payments, and all those bad things.
However, this time around, the sheer magnitude of the debt has some people wondering if something else might also happen. We all are well-advised to steer clear of the doomsayers and those who blithely say nothing will happen. The simple truth is that nobody knows. The interesting thing is that this particular set of circumstances has no precedent. Perhaps the closest is Japan who experienced what has come to be known as “the lost decade” after their government tried to prop up the economy during the '90s. Will that happen here? Time alone will tell.
What can you do?
No matter the circumstances, there are always winners as well as losers. If there is one commonality among the winners, it is their penchant to be prepared.
Get Rich Slowly readers know how to prepare for economic downturns:
- Have as little debt as possible but as much capacity to take on debt if needs be.
- Increase the emergency fund.
- Minimize fixed monthly expenses.
- Resolve ahead of time to stay the course as far as possible with investing.
- Position yourself at work as the go-to person as much as possible — those are the people who get let go last.
This is not like the Y2K panic or preparing for the world to end; but it's not nothing, either. We don't have to agree with what is being done, but we do need to know what is happening and how it could affect us. Whether we like it or not, the next recession is not that far away any more — but there is still time to get our financial houses in order. Forewarned is forearmed.
Do you pay attention to what the Federal Reserve does? How do you prepare for a recession?
William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He has a bachelor's, a master's, and a partial doctorate in management and strategy. Author of the book “The Four Seasons of the Economy,” William also assists medium-sized businesses in the use of the Four Season Strategy to help them capitalize on economic cycles. He runs two blogs: Bite the Bullet Investing (investing) and Drop Dead Money (the economy) and writes for several other blogs in addition.