The Federal Reserve had some important transitions in 2014. In terms of leadership, Ben Bernanke stepped down as chairman, beginning his role as a Distinguished Fellow in Residence with the Economic Studies Program at the Brookings Institution. He was replaced by Janet Yellen formerly vice chair. In terms of policy, the Federal Open Market Committee (FOMC) ended its purchasing of securities, capping the portfolio at $4.2 trillion by October, up from $480 million in 2013. Falling prices for oil and consumer goods, a positive for Americans, makes the Federal Reserve situation more challenging. The United States, after posting a five percent GDP gain, flirts with deflation. Accelerated growth coupled with declining prices should occasion a reduction in interest rates, but the central bank is already at rock bottom with zero percent interest rates.
Yellen’s task in 2015 is daunting. Without creating another recession, she must lessen the dependence on extraordinary assistance to a more normalized policy. This goal comes at a time when Europe, Japan, and even emerging economies like China are suffering and the world’s dependence on U.S. growth increases. In fact, in his recent State of The Union Address, President Barrack Obama touted 2014 as a breakthrough year for America, citing the 5.6% employment rate, jobs creation, and the stock market’s high status. With the GOP taking full control on Capitol Hill pushing hard for an “Audit the Fed” bill, the central bank faces these challenges under greater scrutiny.
Viewed by some analysts as an unconventional policy, Quantitative Easing (QE) occurs when a central bank purchases government or other securities from the market in order to lower interest rates and increase the money supply. QE achieves this goal by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Conducted when short-term interest rates are at or approaching zero, QE doesn’t involve printing new money.
Despite its unconventionality, Maria Draghi, European Central Bank president, made a statement announcing the expansion of asset purchases (QE) on January 21, 2015, a day after Obama’s Address. The ECB’s intent to buy EU$60 billion in bonds each month until the end of September 2016 is designed to prevent the current deflation from becoming a protracted depression. Robert Shiller, PhD, Noble Laureate and distinguished economist, in a recent NDTV Switzerland interview, reminds that the effect of QE is unpredictable. As he discusses in his book, Irrational Exuberance, “people’s reaction to speculative market actions depends on the narrative happening at the time.” For instance, low interest rates between 2012 and the present have home buyer’s thinking that they should buy, because it is logical that rates will go up. ECB’s aggressive QE strategy may help boost housing demand in Europe as it did in America and bring the Eurozone out of deflation. This hope is mitigated by analysts countering that the strategy is delayed. The Federal Bank began its third round of QE back in December 2012, increasing buys from $40 to $85 billion dollars per month. Due to its open-ended nature, the policy earned the nickname of “QE Infinity.”
The greater question is what long-term affect will QE have in the long-term? The U.S. Central Bank’s three rounds of QE have helped fuel the current bull market. The trillions of dollars pumped into the economy through asset purchases has resulted in a Dow Jones Industrial Average, at its 2014 peak, a climb of 170% since its 2009 lows, and the S&P500 is up more than 200%. The goal of QE was to force investors out of low-risk, low-yielding assets and into equities. In turn, the plan was to fuel a boom and create wealth to facilitate consumer spending. That’s why the financial community fears the end of QE. Money Morning’s Small-Cap Specialist, Sid Riggs argues that “the historical facts just don’t support the fear” of a stock market crash once the Fed raises rates again” in spite of the aftermath of Bernanke’s tapering announcement in June of 2013. Then, stock markets dropped by ~4.3% over the following three trading days with the Dow Jones dropping 659 points between 19 and 24 June, closing at 14,660 at the end of the day on 24 June. In September 2013, the Fed decided to hold off on scaling back its bond-buying program.
Draghi has said that the ECB “will do whatever it takes.” In Japan, Prime Minister Shinzo Abe wants the yen to plunge in order to drive export-driven growth. Under Yellen’s direction, 2014 saw the economy come closer to the Fed’s interpretation of congressionally mandated dual objectives of maximum employment and stable prices, resulting in an adjustment of its intentions about holding its policy rate near zero as it had been doing since the Lehman debacle of 2008.
Monetary policy alone cannot make an economy grow faster over time, and it can’t fix all that ails an economy. But it can buy time for politicians to do what needs to be done. That was true for the U.S. then, and it’s newly relevant for Europe today.
Shiller predicted a collapse of the US housing market, and economic collapse in September 2007, a year before Lehman Brothers took its colossal fall. This week in a CNBC Squakbox report, he said investors increasingly feel that the market is overvalued and a financial crisis is possible. Shiller’s Cyclically Adjusted Price-Earnings (CAPE) ratio measures whether the market is fairly valued. CAPE is tied with the pre-crisis peak in 2007, and now indicates that stocks are overvalued. Of course, he admits that bonds are pricey, too.
So, is QE really done? It’s hard to know, and it’s impossible to tell what affect it will have on investments in the long-term.
Regardless, it is important to have a portion of one’s assets in investments like fixed annuities and long-term-care — investments that have no market risk yet can protect clients from out living their income and protect them from unforeseen long term care issues. Recommending products from companies with solid management, A-ratings, and long histories is a path that breeds economic success regardless of what the Fed is doing.