QE has been in the news a lot as markets prepare for the Federal Reserve to begin reining in its loose monetary policy and we look forward to a new Fed Chair in 2014. As with many complex economic topics, there’s a lot of misinformation and confusion about what quantitative easing is and how it affects the economy.
This article will attempt to dispel some of those myths and provide you with the information you need to explain QE to your clients and reassure them when the Fed finally begins to taper.
Myth #1: Quantitative Easing is the Fed Printing Money
Oh boy, is this a common misconception. Unfortunately, it’s propagated by an echo chamber of pundits who frequently refer to quantitative easing as “printing money,” fanning the furor of voters worried about public debt. Quantitative easing doesn’t actually increase the amount of money in circulation because the Fed purchases bonds on the secondary market. The misconception exists because when the Fed buys bonds from banks, it credits those banks’ accounts at the Fed with reserves that didn’t exist before.
In a credit-based monetary system (which is the one we have,) most money is created by banks by lending it out to consumers. While the Fed is attempting to lower interest rates and encourage consumer lending when it buys bonds, it’s not directly increasing the amount of money in the system.
Myth #2: The Fed Is Financing the Treasury
It’s important to help your clients understand the distinction between monetary policy (the Fed) and fiscal policy (the federal government.) There is a commonplace misunderstanding that the Fed’s actions are directly financing the Treasury and causing inflation. This is false. The Fed is buying bonds on the secondary market that have already been issued by the Treasury (or by mortgage lenders in the case of mortgage bonds.) The Fed is not buying Treasury securities because there is a lack of demand on the open market, but because the Fed is implementing monetary policy. The only time that the Fed would be required to purchase bonds to meet a Treasury funding shortfall is if investors refused to purchase Treasury securities and the Fed had to step into the breach. Given the strong demand for Treasury securities, this is an incredibly unlikely situation.
Myth #3: Quantitative Easing Causes Stock Market Highs
This is a tough myth to debunk because there’s a lot that goes into stock market movements: investor psychology, market valuations, macroeconomics data, and microeconomic variables on the company and sector level. Over the long term, the stock market will generally mirror the macro economy, but in the short term, that relationship frequently goes out the window.
In the direct sense, the Fed’s bond buying activities will exert upward pressure on bond prices, causing yields to tank, and encouraging return-seeking investors to choose stocks over bonds. However, this alone doesn’t explain recent market highs. Investor expectations of Fed actions definitely play a role, but recent highs can also be explained by large cash inflows, strong corporate profits, and optimistic macro data.
Myth #4: Quantitative Easing Leads to Inflation
This myth is based on a fundamental misunderstanding of inflation. In economics, inflation is defined as, “an ongoing rise in the general level of prices.” During inflationary periods, a single dollar buys less every year. As of October 2013, annualized core inflation, as measured by the Consumer Price Index stood at 1.73 percent, which is well below the historical average of 3.1 percent – after more than five years of Quantitative Easing actions by the Fed. Since the Fed is not printing money (see Myth #1) and not directly increasing the amount of money in the system, it’s not directly stoking inflation.
Now, this is not to say that keeping interest rates too low for too long won’t cause the kind of lending and spending that causes prices to rise. However, our economy is still growing slowly and unemployment is still high, meaning that inflationary pressures are still low and manageable.