Federal Reserve Chairman Ben Bernake and the Board of Governors have a huge problem on their hands. Since the depths of the financial crisis, they have been looking for ways to stimulate the economy just enough so we have companies willing to hire, consumers willing to spend and a government with a manageable deficit. Despite trillions of dollars in stimulus, the economy is just barely improving. The Federal Reserve needs to decide if we can afford more of the same or if it’s time to start tapering off the economy’s addiction to stimulus before the Central Bank is completely tapped out of resources and credibility.
A Primer on the Fed
The Federal Reserve is the Central Bank of the United States and it, in effect, sets the level of interest rates in the economy. The goal of the Fed is to ensure that interest rates remain low enough for companies and consumers to be attracted to borrowing money but not so low that reckless borrowing spreads like a virus.
The Federal Open Market Committee (FOMC) at the Fed first decides on a “sweet spot” for short-term interest rates and then takes certain actions to achieve that goal over time. When the FOMC believes that inflation is getting too high, it sells government financial instruments known as Treasury securities to banks. Banks are happy to buy these instruments because they carry no risk and generate a modest return. The banks pay the Fed with cash. This means that buying banks have less cash available to comply with federal regulations and must go out and borrow cash from other banks. This increased demand for borrowing raises the price of money—interest rates. When the FOMC believes that the economy is at risk of high unemployment, it takes the opposite action; it buys Treasury securities from banks to give them more cash, reducing the need for inter-bank lending, which in turn lowers interest rates.
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After the housing bubble burst and the 2008 financial crisis, the Fed took actions to lower interest rates to practically zero. But with so much economic uncertainty, even free money wasn’t enough of an attractor to stimulate borrowing and economic activity. The Fed needed to take more drastic measures and did so via Quantitative Easing (QE). With QE, the Fed starting buying non-government financial securities like mortgage bonds and paid for them with cash. This increased the amount of cash on banks’ balance sheets—by billions of dollars daily. In theory, that should have forced the banks to start lending more to consumers, small businesses and large corporations. That hasn’t taken place to the extent expected.
Where We are Today
The Federal Reserve is currently on its third round of QE. It has now purchased a mind-boggling $3.4 trillion worth of government and non-government securities, in effect pumping trillions of dollars in cash into the banking system. The current program consists of $85 billion per month of purchases; about half of these purchases are mortgage securities and the other half government securities. Despite such a vigorous buying program, the economy is only experiencing tepid growth. Interest rates are starting to creep up given the ocean of cash that the Fed has unleashed. The marginal benefit of each additional month of borrowing is diminishing.
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The Fed is likely to announce a tapering of these purchases, probably down to around $60 billion to $65 billion per month starting in the fall, according to numerous analysts. They will then cross their fingers and see how the economy reacts. If key economic indicators like lending, hiring and consumer purchasing aren’t impacted, the Fed will continue to wean us off of so much stimulus. If we do see a significant pullback in economic activity, we will need to find new ways to stimulate the economy, as a fourth round of QE is unlikely to help.
What This Means for Your Business
The next six to 12 months are critical for determining how the economy will perform over the next five years. The reduction in QE, new taxes on employment and investment income as well as the full implementation of health-care reform all signal more uncertainty. That usually means lenders will be more cautious and large companies will think twice before expanding. It’s important to keep track of economic indicators to determine in which direction the economy is headed. The easiest and most comprehensive source is the Beige Book.
You should also expect an increase in interest rates. After being near zero for so long, they are starting to increase as the expectation of less QE means less new cash available to banks for lending activity. The greatest increase will likely be in housing loans, as half of the Fed’s purchases are in mortgage securities. That could stop the nascent housing rebound being observed in many markets. Smooth sailing isn't in our immediate future, no matter what happens—so be prepared for a bumpy ride.
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