Many stock market investors have, in the back of their minds, the comforting illusion that the Quantitative Easing with which the Fed showered Wall Street during the past three years could restart if the market falters. (Under Quantitative Easing, the Fed gave banks $85 billion each month to help stimulate lending and spending and to drive up stock prices). Some also see that the impending rise in interest rates can be reversed if the economy begins to drop. Both assumptions are really illusions. The factors that impelled an end to Quantitative Easing and to higher interest rates rule out a reversal of either policy. Instead, mutually reinforcing higher rates and tighter monetary policy are the most likely paths in the future. Here’s why:
Low Interest Rates Aren’t Working And Are Causing Long Term Rates To Rise
The Fed has no control over long term interest rates and can only raise or lower short term rates by fiat. As short term interest rates have dropped to zero and the Fed has pumped trillions into liquidity via quantitative easing (QE), long term interest rates, determined by the bond market, have steadily risen. As bond buyers have seen the Fed wantonly expanding the money supply, their fears of inflation have driven them to demand higher interest for long term loans. Ultimately, this rise in long term rates is inhibiting the economic growth the Fed had hoped to encourage with low short term rates. So QE has backfired. That’s why its over.
Now, unless the Fed convince the bond market that it has gotten religion and won’t be profligate with the currency, the market will continue to add to long term interest rates because they are freaked by inflation.
The situation is analogous to that confronting President Clinton when he took office in 1993. The bond market needed to be convinced that he would balance the budget in order to get it to lower long term rates. So Clinton needed to raise taxes. Now the Fed needs to raise short interest rates to bring down long term rates.
Quantitative Easing No Longer Is An Efficient Way To Expand The Money Supply
The Fed does not print money, as some have suggested. It creates liquidity. It exchanges its own paper for less liquid mortgages and other paper banks are holding in their vaults.
But this swap does not create money…yet. It is only when the recipient bank lends the money to a business or an individual that money is created. To convert the Fed paper into cash, someone must be willing to borrow and a bank must be willing to lend. No borrowers, no lenders mean no new money is created whatever the Fed does.
With doubts about the economy and fears of inflation, many corporations, flush with cash reserves themselves, see no reason to incur additional debt. They aren’t spending their current cash reserves because they have no confidence in the economy, so why should they borrow more money?
By the same token, those who do want to borrow funds are generally insolvent and banks, with regulators breathing down their necks, are unwilling to lend them money.
Without Enough Borrowers, QE Cannot Create Money
Quantitative Easing Could Not Continue, Nor Can It Be Restarted Due To A Shortage of Quality Bonds in the Market
When quantitative easing started, the Fed looked for banks to swap quality paper for Fed paper. But soon the supply of low risk, high quality bonds in the banks’ portfolio was used up, so the Fed began to settle for mortgage backed securities instead.
But, now, the supply of even that is drying up so the Fed finds it increasingly difficult to find marketable paper out there for which to swap.
So, the message to investors is: You’re on your own. Don’t wait for quantitative easing or continued low rates. The cavalry isn’t coming.
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