Chart of the Month – January 2019

The Real Impact of Quantitative Easing

The statement issued at the most recent meeting of the Federal Reserve Open Market Committee (The Fed) showed a distinct softening in the Fed’s approach to monetary policy. This is important because it may signal that the Fed believes the economy is weakening and they do not wish to drive it into a recession. The chart above gives a very clear illustration of the fact that the Federal Reserve generally stops tightening shortly before the economy falls in recession. It is the Fed’s job to ensure that the economy does not overheat and drive inflation to levels that are destabilizing to the economy. It also appears that the increase in interest rates over the past few years has been significantly more muted than the previous tightening efforts that have eventually driven the economy into a slowdown. The first chart shows how the Fed dropped interest rates to almost zero and held them there for some considerable period to give the economy a chance to recover from the Financial Crisis of 2008. This chart however does not tell the whole story. Once short-term interest rates reached 0.25% it appeared that the Fed was out of ammunition with which to spur the economy at which point it embarked on a massive debt purchasing program which had the effect of taking debt securities (bonds) out of the market and forcing longer-term interest rates lower. This became known as Quantitative Easing. This process enhanced the economic impact of low short-term rates. To measure the impact of this process two economics scholars Jing Cynthia Wu and Fan Dora Xia developed an algorithm to equate the impact of Quantitative Easing to changes in the Fed Funds Rate.

This is shown in the chart below. From this chart it is apparent that the Federal Reserve’s easing program in the aftermath of the Financial Crisis continued well past the last rate cuts in 2009 as the bond purchasing program continued to ease the monetary system into 2014. By then the effect of the bond purchases was the equivalent of taking interest rates to approximately -3%.

Consequently, when one reviews the tightening that has taken place since 2015 one sees an effective rate hike of over 5% which is larger than most programs since the reign of Paul Volker in the seventies when the Fed was fighting a massive outbreak of inflation.

This puts a very different spin on the Fed’s recent activities. Yes, they needed to claw back some of the excess liquidity in the system. With a reasonably strong economy they were able to do this but we are seeing indicators that the economy is weakening and with it the Fed’s rhetoric is softening. Far from looking at a further three rate hikes, it is possible that the next Fed move may be to cut rates. This is the opinion of former Fed Chair Janet Yellen.