What does Quantitative Easing mean for me now?

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?

More about...Economics, Planning

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J. DuLong
J. DuLong

Excellent advice on how to prepare for a possible coming downturn, but what about people on the brink of retirement or just retired who are worried about sequence risk? What advice would you give them?

William Cowie
William Cowie

(For those who don’t know the term sequence risk, it refers to the fact that a retiree who retires at the top of a market could end up getting much less than someone retiring at the bottom of a market.)

I’m recently retired, and my approach is to focus on investments where I only earn income, but never have to touch the underlying investments (either preferred or dividend aristocrat stocks). This means I’ve been unaffected by the underlying value going up or down.

It may not be the best approach in everyone’s case but it works for us.

Paul
Paul

Hussman Funds posted an interesting article a few weeks ago titled something to the effect of “If you will need the money in the next eight years, sell the investment now.” That may not be bad advice if you are on the cusp of retirement and can’t afford to see a 30%+ drop in the value of your investments.

Nathan
Nathan

J. Dulong, You may be running into this issue if you’re relying on the “traditional” age-based asset allocation model (i.e.: invest your age in bonds or something like that). What I’ve found most retirees prefer (both for practical and psychological purposes) is using a “bucket method”. Simply set aside the money you might need from your investments for the next 5 years and put that in short-term bonds/cash. Years 5-10, put in 25% to 50% stocks. 10-15 years put in 50% to 75% stocks. And Years 20+ put 100% in stocks. That way, you can know for sure that, even… Read more »

Cullen
Cullen

There is so much wrong just in the first third of the article that I couldn’t finish it. What does a chart labeled “The US Economy” even mean? What does the Y axis measure? GDP?

But the statement “Rising interest rates is what leads to recessions” really takes the cake. Interest rates are a response to conditions, not a cause of conditions. Interest rates didn’t cause the 2007-2008 crash.

William Cowie
William Cowie

If you look at the second chart, you see rising interest rates precede every recession. Some say it’s a cause, others see it merely as a signal. Given that rising interest rates precede (lead) a recession, I look at it as a time to begin preparing. If you don’t think you need to prepare, that’s fine. 🙂

Paul
Paul

Yeah, what DOES the “U.S. Economy” chart represent? GDP? Inverse of unemployment? S&P 500?

Nick @ Millionaires Giving Money
Nick @ Millionaires Giving Money

Very informative William. QE has made my life easier because my mortgage payments are lower but that hasn’t stopped me from trying to make overpayments so that when interest rates do rise I would be that negatively effected. Great post, thanks for sharing.

Daniel
Daniel

Really great post that spells it out for us mortals. One question: Does it make sense to short sell some index fund tracking stock, given that we can be fairly sure this dip is coming? I generally am a buy-and-hold mutual fund investor, and know just enough to be dangerous. But I have read that short-selling is a way to profit in a downturn. It’s tempting to see this downturn as a fairly “sure bet”, and wonder if that would be a way to benefit. As a follow-on, is there a way to tell if my mutual funds are already… Read more »

ciwood
ciwood

As good as selling short sounds, the average person is much better off determining how their portfolio fared in the 2008 bear market and moving enough stock into bonds or money markets that they can live with a market downturn. You could chart using morningstar.com

VWINX 70%bonds/30%stocks Conservative
VWELX 40%bonds/60%stocks Moderate
VFINX 0%bonds/100%stocks Aggressive

Trying to time the market is a low probability gamble but confirming that your portfolio is positioned to allow you to sleep at night during the next market drop shows great wisdom.

William Cowie
William Cowie

Daniel, What sets me apart from most bloggers in the investing and personal finance space is I stay away from specific recommendations. I strongly believe one size does not fit all; every person has to figure out what suits their situation the best. That’s why my posts are big on information, small on recommendations. If one understands sound thinking, and knows how to listen to what’s being said, one makes better decisions. To paraphrase that old saying, I love teaching people how to fish, rather than giving them fish. My own site (link above) is aimed at people who want… Read more »

Paul
Paul

Daniel, keep in mind that a downturn has been a “sure bet” for years now. If you’re worried about losing money in a downturn, I’d recommend selling a part of your investments now and waiting to re-purchase until stocks drop 20% or more.

Bill Morton
Bill Morton

“Quantitative Easing” – My first thought was that the phrase was a new way of saying “layoff”, like “We are going to quantitatively ease our workforce by 10%”.

Mick
Mick

I’d like to point out there are differing views about how the Fed causes recessions. Some view what the Fed has done prior to every recession (low interest rates, monetary expansion which typically leads to inflation) which leads to mal-investments (i.e. housing boom, internet boom). Eventually the market wakes up (the Fed raises interest rates which makes all of those mal-investments upside down/ unprofitable) and the recession begins.

Economizar dinheiro
Economizar dinheiro

Very Good Article!

I’m from Brazil and the crisis in Petrobras is more difficult to get good analysis of chi market in Brazil, so I have to resort to your blog.

Reece
Reece

This is brilliant. A real explanation of what quantitative easing means, in a way that can be understood by anyone.
I found it really insightful.
Thanks for the great post. I’m now off to pay off my debts and save my emergency fund!

Peter
Peter

I heard back during the civil war the Union Navy cut off New Orleans from getting supplies which the Confederate states heavily relied on for income from sales to Europe. Once this happened the Confederate states started printing money out of thin air. During the war the confederate dollar was $0.90 cents to the U.S. dollar. After the war it went down to 9 cents.

What the Fed is doing is much worse.

Wiggles@FirstYouGetTheMoney

I hope many people read this article. You hear the term quantitative easing thrown around all the time but it goes over most people’s head. Everyone should have at least a basic understanding of the Fed’s workings.

Dave
Dave

QE is one of those topics that always makes me nervous. But knowledge and preparedness are the only thing we can use to combat it, so thanks for this rundown.

Laura
Laura

Well, to answer the questions that the author asked: Do you pay attention to what the Federal Reserve does? Yes, I do. My business is mergers & acquisitions (in every day terms – I sell companies for people so that they can turn that illiquid investment into cash in the bank). So interest rates and the availability of bank debt to finance the purchase of businesses is really critical to my ability to sell a company. These last few years, with interest rates at such low levels have been great – well, at least since the banks eased off and… Read more »

Hiran
Hiran

Thank you for the excellent article!! 🙂

Jacob
Jacob

I think we all need to be aware of the doom and gloom prospects out there. I don’t think a rise in interest rates means recession. If it does, it is a buying opportunity in equities as you can see from history, a downturn was an excellent opportunity to buy on the dips for an index fund or a high quality American company.

William Cowie
William Cowie

Update: Ben Bernanke (previous Fed Chair) started his own blog. His first post dealt with what the Fed can and cannot do about interest rates.

So, from the (retired) horse’s mouth:
http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/30-why-interest-rates-so-low

Jacob
Jacob

There are too many people out of work to worry about inflation. Don’t let QE scare you and I believe it has ended if I am not mistaken. Not worth taking any more time thinking about than you did reading this post.

Me
Me

QE is a fancy term for legalized debasement of the currency. So let’s first start off with asking the question, “what would happen to you if you started your own ‘QE’ program?” That is called counterfeiting and you would go to jail for 15 years. So why is that a crime? Wiki has a good enough description… Some of the ill-effects that counterfeit money has on society include a reduction in the value of real money; and increase in prices (inflation) due to more money getting circulated in the economy – an unauthorized artificial increase in the money supply; a… Read more »

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