It’s over: The third iteration of quantitative easing, or QE3, is ending, the Federal Reserve announced at the end of this week’s two-day policy meeting. Starting next month, for the first time since QE3 began in September 2012, the central bank will not make any moves to expand its balance sheet with new asset purchases.
The Fed has been buying mortgage-backed securities and long-term Treasury bonds in an extraordinary measure to combat the high unemployment and low inflation that plagued the economy after the Great Recession. Over the course of three versions of QE, the Fed’s balance sheet ballooned from $869 billion in 2007 to about $4.5 trillion in 2014.
The investment portfolio will stay at that monstrous level until the liftoff of short-term interest rates. The Fed said in its monetary policy statement released at the end of the meeting that it still expects to keep rates at their current ultra-low levels “for a considerable time.”
“For the foreseeable future, the Fed will reinvest the coupon and principal payments from its portfolio, so as to keep the balance sheet from shrinking,” says Jim Kochan, chief fixed-income strategist at Wells Fargo Funds Management. He adds that the process of shrinking the balance sheet will begin when the central bank starts raising rates again.
“To begin that process now would be a tightening of policy,” he says. And the central bank is in no hurry for that.
A ‘meh’ economy
A midsummer rebound has turned into something of a slump, at least in terms of the factors most concerning to the Federal Reserve.
The economy is still a mixed bag, despite some positive news since the last Fed meeting more than a month ago. Consumer confidence, as measured by the Conference Board, came in much better than expected this week, and in September the unemployment rate fell to 5.9 percent. But inflation remains weak in the U.S. while Europe teeters on the brink of recession.
“The performance of the U.S. and European economy is not strong enough to make it clearly obvious that an increase in rates is appropriate,” says William Poole, senior fellow at the Cato Institute and former president of the Federal Reserve Bank of St. Louis.
“In the U.S., things seem to be OK, but I wouldn’t call this a gangbusters recovery. There’s been no obvious increase in growth. There has been no indication that things are breaking out on the high side,” he says.
Best laid plans of mice and central banks
The central bank has a dual mandate: controlling price stability, or inflation; and facilitating maximum employment. While the worst of the crisis in the labor market seems to have passed, inflation hasn’t yet kicked in significantly.
Fed policymakers on the Federal Open Market Committee set an inflation goal of 2 percent, but prices have yet to cooperate. In August, core inflation registered at 1.47 percent, according to the personal consumption expenditures index, the Fed’s favored inflation-tracking metric.
“Inflation expectations have fallen sharply,” says Paul Edelstein, director of U.S. financial economics at IHS Global Insight.
The statement from the central bank today nodded to the divergence between their forecast and the opinion of the bond market.
“Inflation has continued to run below the Committee’s longer-run objective. Market-based measures of inflation compensation have declined somewhat; survey-based measures of longer-term inflation expectations have remained stable,” the statement read.
“If you look at five-year TIPS spreads, they were a little over 2 percent in June,” Edelstein says, referring to a popular method for estimating future inflation. “They were just under 1.5 percent last week, so they have deteriorated a lot. We haven’t seen inflation expectations this low since 2010, before the Fed did QE2.”
How the Fed has seen various indicators:
|Fed statement||Economic growth||Labor market and unemployment||Household spending / Business investment||Housing||Inflation|
|Oct. 29||Economic growth: Expansion at a moderate pace.||Labor market and unemployment: Improved somewhat further, with solid job gains and lower unemployment.||Household spending / Business investment: Rising moderately. / Advancing.||Housing: Recovery remained slow.||Inflation: Some measures declined somewhat, others remained stable.|
|Sept. 17||Economic growth: Restraint from fiscal policy is diminishing.||Labor market and unemployment: Improved somewhat further. Unemployment is little changed.||Household spending / Business investment: Rising moderately. / Advancing.||Housing: Recovery remained slow.||Inflation: Below the Fed’s targets.|
|July 30||Economic growth: Rebounded in the second quarter.||Labor market and unemployment: Improved. Unemployment declined further.||Household spending / Business investment: Rising moderately. / Advancing.||Housing: Recovery remained slow.||Inflation: Somewhat closer to the Fed’s targets.|
|June 18||Economic growth: Rebounded in recent months.||Labor market and unemployment: Showing further improvement. Unemployment, though lower, remains elevated.||Household spending / Business investment: Rising moderately. / Resumed advance.||Housing: Recovery remained slow.||Inflation: Below the Fed’s targets.|
|April 30||Economic growth: Picked up recently after winter slowdown.||Labor market and unemployment: Mixed but improving. Unemployment remains elevated.||Household spending / Business investment: Rising more quickly. / Edged down.||Housing: Recovery remained slow.||Inflation: Below the Fed’s targets.|
The future will be data-dependent
Despite the dour view of the market, the economic projections of FOMC members released in September offered a slightly sunnier outlook on prices, pointing to a consensus view that 2 percent inflation could be reached by 2016.
Why would the market assume such a pessimistic stance despite a more encouraging forecast from the central bank? The Fed has an answer for that hidden in the minutes of its September meeting: Market participants are pricing in downside risks based on their own judgment of best- and worst-case scenarios.
On Monday, an economic note from High Frequency Economics pointed out that the Fed’s projections are much more narrow in scope and “are intended to signal what to expect if baseline economic projections are realized.”
Only time will tell which scenarios come to pass. The important point for today is that the latest round of QE has ended. Now, it’s time to look at more economic data.
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