QE and Ultra Low Interest Rates: What Happens When It Ends?
After five years of continuous stimulus, the US Federal Reserve has finally started tapering its quantitative easing program. While the official interest rate is not expected to increase yet, Chair Yellen has indicated that this could be as soon as 2015. With a little bit of hindsight we can now determine how these policies have supported the market, and can begin to see the effect their removal might have.
The magnitude of the GFC required a complimentary set of stimulatory policies to support a revival. This included near zero interest rates, quantitative easing and forward guidance.
The US is not the only country with ultra low interest rates. Key economies have kept rates extremely low ever since the crash. Despite already technically emerging from recession there is only recent signs that this approach to official interest rates will change.
Quantitative easing has been an important tool for the US Fed to increase liquidity in the market. This graph clearly shows that the balance sheet of the Fed has tripled with the implementation of the program and has recently swelled to a staggering $4 trillion (or roughly 12 times the entire Australian government budget).
Other key economies have employed similar unconventional policy measures which have also resulted in swollen balance sheets. This graphic shows that the balance sheets of key central banks more than doubled between 2007-2013.
All of these policies involve the relatively artificial creation of money and money supply, intended to stimulate economies away from recessions and into growth. Research by McKinsey Global Initiatives indicates that these policies have been successful (compared with a no-action scenario) and unconventional monetary policies such as quantitative easing have improved global GDP by between 1-3%, reduced the unemployment rate by about 1% and prevented deflation. All important factors in strained economies – however like most broad policies, some groups benefit more than others.
All that money, what did it do?
Unconventional monetary policies have had differing distributional effects on diverse sectors of economies. As the graph shows across the US, UK and the EU, central government and non-financial corporations have increased their net interest income, while households, insurance and pensions positions have worsened. In this sense ultra low interest rates have reduced returns to frugal savers while reducing costs to high spending borrowers.
The difference of distributional effect is seen more clearly when broken down by sector. Between 2007-12 governments in US, UK, and EU have collectively benefited by $1.6 trillion through reduced debt service costs and increased profits remitted from central banks.
Non-financial corporations that borrow heavily have also reaped benefits from lower rates. US firms have saved approximately $310 billion in interest expenses since 2007. These savings translated into a 5% increase in 2012 corporate profitability and a little more than 20% increase since 2007. This, however, has not been reflected in an increase in investment and has predominately only resulted in strengthening the balance sheets of the largest US corporations.
US banks have been able to keep their rates on deposits low and loan rates high to increase their net interest margins. As the graph shows, this has not been the case for UK and EU banks. EU banks have had to raise rates on deposits to attract investors while lowering rates on loans to satisfy large corporate clients.
GFC policies have been both good and bad for households. Those holding debt benefited, while those dependent on interest income suffered. Interestingly, age and other demographic characteristics drive the relative impact of lower interest rates on households. For example, in the US, younger households tend to be ‘net debtors’ as such they have gained from lower rates. Net savers on the other hand have lost.
Effect on assets
Ultra low interest rates have also affected stocks, bonds and real estate in different ways.
Bond prices (which generally move in the opposite direction of interest rates) soared 37% in the US between 2007 and 2012. This increase along with the increase in the Eurozone is seen clearly in this graph. On a mark-to-market basis, the value of sovereign bonds in the US, UK and the EU increased by $10.8 trillion and the value of corporate bonds outstanding rose by $3.0 trillion.
The relationship between low interest rates and the surge in the stock market seems to be less direct than popular media would indicate. It is apparent however that the quantative easing programs implemented by the Fed have coincided with declining stock market volatility.
The impact on the housing market seems to be unclear.
The inverse relationship between mortgage rates and housing prices has not been apparent in the US experience.
The relationshop has been very clear in the UK.
The surge in portfolio bond flows to emerging markets coincided with the start of the US Fed’s large scale debt securities buying in 2009. As the graph shows yield starved investors more than tripled their exposure to emerging market bonds between 2009-12.
All things must come to an end
Former Chairperson Ben Bernanke foreshadowed the possibility of tapering in May last year, but it was not until January 2014 that this possibility became real. The questions that now abound are how the winding back of the stimulus will affect the global economy.
As we saw in June last year the stock market moved sharply after the announcements, but subsequently reversed over following weeks.
Movements in the S&P500 in the last six months demonstrate the responsiveness of the market to Fed announcements.
With the June announcement of a possible taper, capital started to draw out of emerging markets. The actual reduction in quantitative easing in January 2014 caused mayhem for emerging economies. EPFR Global indicates that emerging market equity fund outflows have already surpassed the whole of 2013.
As the US economy improves we are likely to see an increase in US interest rates. Chair Yellen has indicated this will not occur until 2015. It is predicted that for every 100 basis point increase in rates, US household debt payments will increase by 7%. A similar hike in the UK interest rate will increase payments by 19%.
An increase in US interest rates will also make countries heavily dependent on foreign investors and with large current account deficits susceptible to balance of payment problems as internal funds dry up.
Good news? Bad news?
On the whole, the good news is that if the Fed continues to taper and official interest rates lift, it signals an improving economy and strengthening labour market. While the Fed is committed to closing the quantitative easing chapter, there is little impetus to do it quickly.
As Fed Chair Yellen again made clear in early April, the unemployment rate, currently 6.7% is not a sufficient statistic to measure the health of the labour market. She mentioned the seven million part time workers who want full time work as an explanation of this. As the graph shows, total unemployment including all marginally attached and part time for economic reasons pushes the rate to 12.5%.
Further analysis of the long-term decline in the participation rate indicates that stimulatory policies by the Fed have not led to great improvements in the labour market and instead has led to more people dropping out of the market.
After five years of unconventional monetary policies the Fed has finally signaled an end. It is difficult to predict the absolute end however, as labour data remains soft. This is not expected to change the overall taper path. Rather the ‘extraordinary commitment’ to ultra low interest rates is expected to abate by 2015. To be sure, the end of cheap money is coming.