To Have Your Cake and Eat It Too

The Legacy of Quantitative Easing

In a previous piece, I discussed how Federal Reserve interest rate policy affects markets and the economy with lingering effects. 9.22.24 This note will focus on the other part of monetary policy, Quantitative Easing, which has arguably been more important in the last 15 years.

Free Money (but not really)

In the depths of the Great Financial crisis back in 2008, the banking system was collapsing, and financial markets were in full-blown panic mode. The Federal Reserve’s normal courses of action were not working. Zero interest rates proved inadequate to calm the markets, because borrowers couldn’t service the debt they had, much less take on new debt. Lenders were reeling from losses, and in no mood to make new loans. Interest rates are mostly useless for conducting policy if no new lending is taking place. In order to stabilize the economy and markets, the Fed introduced Quantitative Easing (QE), whereby they purchased massive amounts of U.S. Treasuries to flood the system with liquidity. Along with some herculean policy efforts by congress, this calmed markets enough to keep the system together.

In mid-2009, the economy stopped collapsing, and a new long-term expansion began. Below is a chart of the Federal Reserve’s Assets (red) and the Fed’s Target Policy rate (blue), with recessions shaded grey. Prior to the end of recession, the Fed had doubled their balance sheet to $2 Trillion, which was enough to allow natural economic forces to start to take hold, but it wasn’t enough to return the economy to robust growth.

Chart 1: Fed’s Total Assets with Target Policy Rate

A Global Effort

All major global central banks were doing QE along with the Federal Reserve. But an interesting fact is that whenever one central bank tried to reduce its balance sheet, it’s domestic economy would start the weaken. However, the head of the Fed, Ben Bernanke, didn’t even attempt to draw down the Fed’s balance sheet for eight years! The chart shows a stairstep pattern in the Fed’s Assets as it invariably moved higher. Often to offset weakness caused by other CBs performing Quantitative Tightening. The Fed topped out its balance sheet at about $4.5 Trillion at the end of 2014 and stayed there for the next 3 years.

In 2018, the U.S. economy showed enough momentum that the Fed finally saw fit to start Quantitative Tightening and raising interest rates. The TCJA tax cuts implemented at the beginning of 2018 probably helped growth, since they were funded by deficit spending. Unfortunately, QT didn’t last long. By September 2019, with some analysts starting to predict a recession, the Fed was already expanding their balance sheet again and cutting rates.

Covid Hits

It’s impossible to know whether the U.S. would have slipped into recession in 2020 had Covid not come along, or if a soft landing could have been engineered. Which is unfortunate, because it would have given us a clearer idea of the long-term effects of QE. That is, at what point, if ever, will QE not be required for the economy to sustain long-term growth. It may seem like an academic argument, but it’s not. For the foreseeable future, QE isn’t going anywhere, and the implications for the economy and markets are ongoing.

Everything started to shut down due to Covid in March of 2020. Just like in 2008, congress implemented emergency programs, and the Federal Reserve exploded its balance sheet again through QE. This time Fed assets grew to over $9 Trillion! Double the top after the GFC. With an economy that was largely shut down, but the U.S. Government supporting people’s income through various programs, and the central bank doing a monstrous amount of QE, the Personal Savings Rate (pictured in Chart 2 in Red) skyrocketed to 32% in the beginning of 2020, and averaged 20% for the year, versus a 4% average for the last 25 years. Massive savings were funded by the largest Federal Budget Deficit (Blue) since WWII, at almost 15%. Since the economy was virtually closed for business, and people were terrified, consumers forewent spending, which created pent up demand that has allowed for a more resilient economic expansion. For those wondering why the most rapid rate hikes in decades hasn’t thrown the economy into recession (at least not yet), this is a major part of the answer.

Chart 2: U.S. Government Deficit with Personal Savings

Everything Bubble

By the end of 2020, the SPX had taken out its all-time highs despite the fact the economy was still in dire straits. New highs in the stock market were only a portion of what was beginning to be called the “ Everything Bubble”. Speculation in various assets reached absurd levels, such as millions of dollars being paid for worthless crypto assets (NFTs).

In 2022, a sharp rise in inflation brought about an end to the Fed’s Zero Interest Rate Policy (ZIRP), and QE. They embarked on the sharpest rate hike cycle since the early 1980s, which thrust global assets into a bear market, with the SPX down around -28%, and major tech stocks down over -50%.

While the economy slowed, it narrowly avoided a double-dip recession, supported by pent-up demand fueled by Fed liquidity and government deficits. However, that same liquidity, combined with supply chain disruptions from the Covid shutdowns, became a key driver of rising inflation.

Many (myself included) believed it was virtually impossible to avoid a recession with such rapid rate increases. But the largest American companies in the tech space, which have dominated the market of late, have very little debt, and therefore, were largely unaffected by the rate increases. Furthermore, many homeowners had locked in extremely low rates during ZIRP, which allowed them to withstand the higher rates. Even though the Fed also started reducing its balance sheet, at around $7 Trillion, it’s still $5 Trillion more than it would be had QE never been implemented. This is an ocean of excess liquidity.

We’re at a significant inflection point right now. If the Fed can manage to lower rates just the right amount to avoid a recession, but not reignite inflation, then this market will likely scream higher. Most analysts have now taken recession off the table, as though a soft landing is a foregone conclusion. But one thing that should be taken note of is that the consensus pretty much NEVER predicts a recession at the beginning. The National Bureau of Economic Analysis (NBER), which designates whether we enter recession or not, typically only calls a recession 6 months after it starts. Good looking economic data is typically revised down prior to a recession. While not definitive of anything, last month jobs numbers were revised down by 818,000 for this past year. Total jobs growth was still decent, but revisions such as these can indicate that not all is as good as it seems. Jobs Revision The majority of economists and analysts are predicting a soft landing. For now, the data supports this assessment.