The big news of last week was the Federal Reserve’s announcement of QE3, i.e., that it would buy $40 billion worth of bonds each month until the economy was back on its feet again. The fact that the commitment was open ended (unlike QE2 and Operation Twist, the two prior big moves by the Fed during the last three years) and directly tied to stronger employment/economy was viewed as positive by the stock market, which jumped about 2% in the two days after. I am sure that I am missing some significant piece of the puzzle, but as I watch the news coverage and market reaction, I am reminded of one of my favorite movies, “Groundhog Day“.
While we can debate the intent behind the Fed move and whether it would succeed at awakening the economy, I would posit three points (all of which I am sure are debatable):
- The Fed does not set market interest rates: Much as I would like to buy into the notion that the Fed sets mortgage rates, corporate bond rates and treasury rates, the only interest rate that the Fed actually sets is the Fed Funds rate, the rate at which banks trade balances at the Federal reserve. In fact, if the Fed has as much power over interest rates as we think it has, the US would not have had double digit treasury bond rates in the 1970s.
- The Fed’s influence on market rates is greater at the short end than at the long end of the spectrum: It is true that the Fed can influence market interest rates through its actions on the Fed Funds rate, with interest rates falling (rising) on signals of a looser (tighter) monetary policy”, but that fall or rise is greatest for short term rates. It is also true, in Operation Twist and continuing into QE3, the Fed is pumping billions into the bond market with the intent of keeping longer term rates low. The bottom line though is that influence does not equate control, and the bond market is far too large for even the Fed to turn the tide (if the tide is running against what the Fed would like to do).
- What the Fed wants to do and what it seeks to accomplish with that action seem at war with each other: If I understand what the Fed is doing, its intent is to keep interest rates low to induce higher real growth (and lower unemployment) in the economy. There is an inherent contradiction between the Fed’s action and its objective. If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. Thus, the only way the Fed can keep interest rates low for an extended period is if low interest rates do not translate into a stronger economy. I would argue that the the Fed’s earlier moves in this recession (QE1, QE2 and Operation Twist) make this point for me. Interest rates have stayed low, with mortgage rates and corporate bond rates at historical lows, but they have done so, because the economy has stagnated.
To address the question of whether the Fed action is good for stock prices/values, I would list three “macro” variables that underlie the valuation of all equities:
- The risk free rate: The first corner of the triangle is of course the risk free rate, i.e, the rate you would earn as an investor on a guaranteed investment. Holding all else constant, a lower risk free rate should translate into higher equity values.
- Equity risk premium: The second corner is the equity risk premium, which is the premium that investors demand for investing in stocks as compensation for exposure to macroeconomic risk, i.e., uncertainty about real economic growth and inflation. Holding all else constant, a lower equity risk premium should translate into higher equity values.
- Real Growth: The third corner is real economic growth, with higher real growth, all else held constant, translating into higher equity values.
If you hold real growth and equity risk premiums fixed, and lower interest rate, the values of all financial assets should rise. But “holding all else constant” is easier said than done. If the risk free rate is low because real growth is expected to be low and/or because investors are fleeing to safe harbors in the face of crisis, whatever you gain from having the lower risk free rate will be overwhelmed by the increase in the equity risk premium and the lower real growth. Thus, as I noted in an earlier post, a lower risk free rate does not always translate into higher equity values. The most charitable assessment I have of the market’s optimistic reaction to the Fed’s action is that the market buys, at least for the moment, into the Fed’s juggling act: that they can keep interest rates low, without increasing macroeconomic risk, while spurring real growth in the economy. I think you could point to a more likely scenario where QE3 does not do much for real growth, while leading to more uncertainty about expected inflation (and higher equity risk premiums) and the net effect on stocks is negative.
Given high unemployment and an economy stuck in neutral, you may feel that the Fed had no choice. After all, doing something is better than doing nothing, right? That would be true, if QE3 were costless, but it does carry three costs:
- The inflation factor: The biggest cost of an expansionary monetary policy is the potential for inflation that comes with it. I know that the low inflation over the last few years has led some analysts to conclude that the inflation dragon has been slain forever. However, history tells us that inflation is like a deadly virus, harmless as long as we can keep it trapped, but hard to control, once it escapes. Put differently, if the Fed has miscalculated and high inflation does return, the cure will be both long drawn out and extremely painful.
- Artificially “low” interest rates create winners and losers: If the Fed’s bond buying is keeping interest rates at “artificially” low levels, not everyone wins. Among individuals, spenders are rewarded and savers are punished, a perverse consequence in a nation that already saves too little for the future. Among businesses, you reward those businesses that have to raise fresh capital, and especially those who are more dependent upon debt, and punish more mature and/or equity-focused businesses. Among sectors, you help out those that are more dependent upon debt-funded consumption (housing, durable goods) and do less for service businesses. Thus, keeping interest rates “abnormally” low may create bubbles in some sectors and encourage people to act in ways that are not good for the economy’s long term health.
- Credibility effect: The powers of a central bank stem less from its capacity to print money (any central bank can do that) and more from its perceived independence and credibility, and I think the Fed has hurt itself on both counts. While I am willing to believe that the Fed acted without political considerations, any major action two months ahead of a presidential election will viewed through political lens, and it is natural for people to be suspicious. In addition, each time the Fed takes a shot at the “real growth” pinata and nothing happens, it damages it’s credibility. Much as the market (and some economists) may welcome and justify QE3, but the ultimate test is in whether it will give a boost to real economic growth and if that does not occur, what’s next?
I was a skeptic on the efficacy of QE2 and Operation Twist and I remain unpersuaded on QE3. If the definition of insanity is that you keep trying to do the same thing over and over, expecting a different outcome, then we seem to be fast approaching that point with the Fed.