In the realm of financial markets, Wall Street often uses a dizzying array of buzzwords and terminology to discuss current events in the financial industry. Admittedly, for novice investors or casual followers of business news, it can be confusing or even intimidating.
Within this lexicon of financial jargon is the Federal Reserve’s expected tapering of its quantitative easing, or QE, program. Now, though some of you may be fluent in what all this means, for many, it may elicit a blank stare coupled with a muffled “heck if I know.” But it’s an important event that will impact most every American, and we can break it down using the simplest of narratives.
To explain the process and importance of quantitative easing requires a brief (I promise!) history lesson. So, take a giant swig of your caffeine-infused coffee and let’s dig in.
From December 2007 to June 2009, the American economy had fallen into recession, caused by the housing bubble and subprime mortgage crisis. To help boost a flailing economy, the Fed dropped the benchmark fed funds rate — upon which short-term debt is often based – to near 0%. The hope was that lower interest rates on credit cards and bank loans would spur consumer spending and economic growth.
Despite the Fed’s efforts, the economy continued to decline while unemployment soared. Unable to lower the benchmark fed funds rate any further, the Fed turned to quantitative easing.
Briefly, QE is when a central bank, in this case the Fed, purchases long-term government bonds or securities. The effect is to increase the money supply while driving down long-term interest rates. The Fed hopes that flooding the economy with cash, combined with lowering long-term interest rates, will artificially create consumer demand for goods and services, thus stimulating economic growth.
Over the years, the Fed has continued its QE program and is currently buying $120 billion per month of government bonds and securities. The problem is, however, the growing balance of these asset purchases has soared to more than $8 trillion. The Fed is concerned the sheer size of its QE program may be causing distortions within the financial markets. With interest rates and bond yields being forced so low, the QE program inherently prompts investors to take greater risks, such as investing in the stock market, in search of higher yields.
But the Fed is soon expected to announce it will start to gradually reduce, or taper, its $120 billion in monthly purchases. Most likely, tapering would begin in early 2022 or possibly in December of this year. Tapering doesn’t mean the Fed will completely end its monthly purchases, only that the monthly quantity will be reduced.
The tapering of the Fed’s asset purchases is not without risk, and the effects on consumers, businesses and the financial markets can be significant. As designed, the QE program served to artificially keep long-term interest rates low. By gradually reducing its asset purchases, the Fed will inherently drive these interest rates higher.
Even if the tapering is done at a slow and predictable pace, it will still raise the cost of long-term debt, impacting consumers and businesses on everything from home mortgages to bank loans to financing of equipment. The Fed has vowed prudence and caution in this endeavor. But with inflation already at a 13-year high, raising additional costs on consumers and businesses could carry tremendous economic risk.
Mark Grywacheski is an expert in financial markets and economic analysis and is an investment adviser with Quad-Cities Investment Group, Davenport.
Disclaimer: Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets or developments mentioned. Quad-Cities Investment Group LLC is a registered investment adviser with the U.S. Securities Exchange Commission.