The US Federal Reserve (Fed) decided in its latest meeting on October 29 to draw the curtains on one of the most remarkable experiments of monetary policy. By stopping its monthly purchases of assets from November—which have been ongoing for over two years—the Fed has put an end to its quantitative easing (QE) program. By all accounts, QE was a big and bold move. However, what impact it had on the US and the world economy remains a controversial issue, something that will be researched for years to come.
QE is defined as a central bank’s purchases of private and public assets financed by the expansion of the monetary base. Since the financial crisis of 2008, the Fed has run three episodes of QE. The first episode, QE1, began in November 2008 and lasted for 17 months. The Fed bought the debt of government entities Fannie Mae and Freddie Mac, mortgage-backed securities as well as long-dated government bonds with the aim of removing low-quality assets from the financial system and encouraging lending in the economy. The second wave, QE2, which was announced in November 2010 and continued until June 2011, continued the purchases of debt securities initiated in QE1. Finally, QE3 was introduced in September 2012 and involved USD85.0bn of open-ended monthly purchases of mortgage-backed securities and long-term government bonds. These purchases were tapered from January 2014 and have come to an end following last week’s Fed meeting. As a result of these episodes, the Fed’s balance sheet nearly quadrupled from below USD1.0tn in 2008 to around USD4.5tn in October 2014.
Why did the world’s largest central bank engage in an experiment of such large scale? The Fed typically fine-tunes the economy through its control of short-term interest rates. As interest rates fall, consumption and investment generally rise, leading to more economic activity. But short-term interest rates reached near zero in late 2008 and could not be reduced any further. Additional stimulus could only be provided by reducing long-term interest rates, which was one of the aims of QE. The Fed’s purchases create additional demand for long-dated government bonds, bringing their prices up and yields down.
The second aim was to ensure the stability of inflation expectations to prevent deflation from being incorporated into prices and wages. This has prompted the Fed to dramatically expand the size of its balance sheet to ensure expectations remain anchored. Third, by removing the relatively safe long-dated bonds from the market, the Fed wanted to encourage investors to hold more risky assets, as the resulting increase in asset and house prices would increase the wealth of private individuals leading to a further boost to private sector consumption. This was the aim in the last two phases of QE.
The outcome on the US economy was indeed positive. The US avoided going through a prolonged period of deflation altogether. The unemployment rate, which peaked at 10.0% in October 2009 has been falling steadily since then and now stands at 5.9%. The search for yield drove the 190% appreciation in US equities since March 2009. Some even argue that QE has gone too far and is causing financial instability and asset price bubbles. Only time will tell whether QE indeed created too much demand for risky assets.
The impact of the Fed QE on the global economy was no less significant. The search for yield extended not only to domestic equity, credit and housing markets but also to Emerging Markets (EMs) bonds and equities. These flows provided a boost to these assets offsetting large current account deficits in some EMs. However, when the Fed indicated its intention to reduce its monthly asset purchases in May 2013, the portfolio flows quickly reversed, exposing the weaknesses in some of these economies. Particularly hurt were the so-called Fragile Five countries (Brazil, India, Indonesia, South Africa and Turkey), which suffered from large depreciation in their currencies following large capital outflows (see our commentary dated September 7, 2014).
The GCC was relatively immune from the EM turmoil which followed the tapering tantrum. The International Monetary Fund has recently estimated that the cumulative portfolio outflows since May 2013 were less than 0.1% of GDP in the GCC—much lower than the rest of EMs, which have been estimated at 0.35% of GDP. Two reasons contributed to the favorable performance of the GCC economies. First, they are less open than other EMs, and therefore less exposed to swings in investor sentiment. Second, the region’s strong external position and large current account surpluses have led investors to view them more favorably than other EMs.
For better or worse, the Fed’s experiment with QE is over. Markets have turned their attention to the date of the first rate hike by the Fed. The Fed’s most recent statement indicated that it is likely to maintain the policy rate at its current level for “a considerable time” following the end of QE. Markets expect the first rate hike to take place in the second half of 2015. The QE chapter might be closed for now, but its impact will be studied and debated for years to come.