U.S. economy
Today the Federal Open Market Committee under Chair Janet Yellen is expected to end the third phase of quantitative easing, which is economist lingo for the Federal Reserve’s purchases of bonds to lower long-term interest rates. (The Fed’s official term is large-scale asset purchases.) In the chart below, note the sharp growth in the Fed’s total assets when its first round of quantitative easing began.
But quantitative easing is the gift that keeps on giving. Even after the purchases end, its effects will persist. How could that be? The Fed will still own all those bonds it bought, and according to the agency itself, it’s the level of its holdings that affects the bond market, not the rate of addition to those holdings. Having reduced the supply of bonds available on the market, the Fed has raised their price. Yields (i.e. market interest rates) go down when prices go up. So the effect of quantitative easing is to lower interest rates for things Americans actually care about, such as 30-year fixed-rate mortgages.
Imagine that the Federal Reserve wants to increase the price of suntan lotion. There are 10 bottles of Hawaiian Tropic for sale at the cabana. The Fed buys one per hour until it owns nine. Each time it acquires one, the price for the remaining bottles rises because people who don’t want to get sunburned are competing for the dwindling supply. Now that just one bottle is left, the Fed stops buying. Would you expect the price of the last bottle to fall suddenly? No—there’s still lots of demand and constricted supply. Same with bonds. The price of bonds should stay high—and yields stay low—as long as the Fed hangs onto its huge inventory.
To mix metaphors, ending QE isn’t putting on the brakes. It’s just easing off the accelerator. The Fed’s bond holdings will naturally shrink as bonds come due; as new debt comes onto the market, the Fed’s portfolio will have less impact. For now, the Fed will continue to reinvest the proceeds back into other bonds. It says it won’t allow the portfolio to start shrinking until after it starts raising the short-term interest rate it controls, the federal funds rate. That’s likely to happen sometime in 2015, most economists expect.
