We are living in interesting times. The Fed Funds Rate is targeted at 0-.25%. The last time it was this low was in the late 1950’s, so it’s fair to say that for most of us, these are the lowest rates we’ve ever seen. As I became interested in finance in the late 80’s, fed funds rose from 6% to 10% before starting its long decline to where we are today. In a grad school economics class I recall a discussion on monetary policy, and the question came up – If the Fed Funds Rate ever went to zero, what tools would the Federal Reserve have to push the economy out of a recession?
We saw the answer. It’s called quantitative easing. Instead of simply driving interest rates down, the Federal Reserve began buying mortgage backed securities, 40 billion per month in the early rounds, now, also long term treasury bonds for a total of $85 billion per month. In effect, this is money being printed and pumped into the system, in the hope that this money will help to spur the economy. The results appear to be a bit questionable. Last August, I wrote Cash Hoarders – QE3 won’t help, in which I discussed the enormous cash hoard that U.S. companies have in their coffers. If their $2 trillion dollar nest egg isn’t encouraging them to expand their businesses and hire more workers, why would QE cause them to behave any differently?
Interest rates on mortgages are also at near record lows, but many who desperately need to refinance to take advantage of these rates are unable to secure a new loan. The banks are requiring higher FICO scores than they did years ago, and people are still stuck with under water mortgages at rates far higher than they should be paying. The money that’s pouring our of the Fed appears to be propping up the stock market, but doing little to help the economy.
Now, for the Taper. When the Fed is satisfied that the economy is on track, as measured by a lower unemployment rate and improving GDP, they will reduce the purchases. Not bring them to a halt, not reverse their position, just Taper a bit. For some reason, the prospect of this happening freaks the market. To be clear, QE which the Fed says is needed because the economy isn’t really as healthy as it should be, and will slow down as the patient improves. But the market prefers the bitter medicine instead of a healthy economy?
Next (on Thursday) – The Velocity of Money. This little understood phenomenon is part of the potential wave of inflation that may occur after QE ends.