What is Quantitative Easing?
“Quantitative easing (QE), also known as large-scale asset purchases, is an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity. An unconventional form of monetary policy, it is usually used when inflation is very low or negative, and standard expansionary monetary policy has become ineffective (source).”
Does Quantitative Easing Work?
We don’t think quantitative easing works. We think that if it works then there should be evidence to support this ideas, little or none exists. Japan was the “first” country to implement the modern version of quantitative easing in 2001. That didn’t result in the same outsized change in the Japanese stock market.
However, some people believe very strongly in the idea that central bank policy in the form of quantitative easing meaningfully affects the economy and liquidity. Surprisingly, the believers are not just fans of central bank intervention but also critics of the existence of central banks.
What Happens When Quantitative Easing Ends?
Fans of central bank intervention suggest that Quantitative Easing ends when the economy and liquidity has been “restored.” The assumption is that everything is alright and the economy will chug along as it “should.”
Critics of central banks say the stock market and economy will suffer without quantitative easing. The view is that, since the market increase was due solely to Federal Reserve “stimulus” then without the injections, interest rate will climb and the stock market should collapse.
While we’re not lined ups as fans of central bank intervention, we believe the critics, mentioned above, are also sorely mistaken in their theory.
A Picture Worth Considering
In an article titled “The Rise and (Eventual) Fall in the Fed’s Balance Sheet” there is a chart depicting the historical level of the Federal Reserve Balance Sheet relative to nominal GDP. The chart, as seen below, potentially implies that, the contraction of the Federal Reserve balance sheet could be the biggest and best thing for the economy and liquidity of the markets.
Interpretation
The last peak in the Federal Reserve balance sheet, relative to nominal GDP, was in the period from 1937-1940. In that period (‘37-‘40), interest rates bottomed out and started a long march to peak in 1981. Also in that time, from 1940 to 1981, the Dow Jones Industrial Average ranged from a low of 42.42 on April 28, 1942 to a high of 1,051.70 on January 11, 1973 (+2,379.25%).
Also worth noting is the minor decline in the Fed balance sheet relative to nominal GDP from 1917 to 1929. In that period, the Dow Jones Industrial Average increased from 69.29 on December 24, 1917 to 380.33 on August 30, 1929 (+448.89%).
The critics of punch bowl economics might be surprised when they find that the exact opposite is likely to happen when the Federal Reserve attempts to reduce their balance sheet AND interest rates increase. History suggests that taking away the “punch bowl” actually improves conditions for greater market stability and liquidity, for a while at least. Sometimes, less is more.