The end of QE2

Recently, more and more Federal Reserve officials have been going on record to say that they believe there is no need to extend the second round of quantitative easing (or QE2) beyond its planned June deadline.

Some of them, such as St. Louis Fed President James Bullard, have even publicly stated that the Fed should stop short of buying the entire amount of securities ($600 billion) anticipated when QE2 was first announced. In a statement this morning, Mr. Bullard said: "We have to get started on the process of getting back to normal on the balance sheet. We are fueling the fire right now, and it needs to be turned around."

"Quantitative easing" describes a Fed method of increasing bank reserves by purchasing securities, which enables banks to lend more money, in effect creating more money in the system without lowering interest rates (hence, "easing" the monetary policy through the "quantity" of assets on the Fed balance sheet). We described the mechanics of this process in this recent blog post.

Chicago Fed President Charles Evans said it would be a "high hurdle" to end QE2 early, but that he did not anticipate needing to go beyond the June end-date or the $600 billion target, as he had previously thought they would. Atlanta Fed President Dennis Lockhart also said there would be a "high bar" to clear to go beyond the target, and Minneapolis Fed President Narayana Kocherlakota said the economy would have to worsen "materially" in order for the Fed to go beyond the target.

Philadelphia Fed President Charles Plosser stated that the Fed would need to normalize its balance sheet and even begin raising rates in the "not-too-distant future."

We have been on record for a long time saying that the Fed is "oversteering" by staying this easy for this long (see here and here), and agree with both Mr. Plosser and Mr. Bullard that the Fed should begin to unwind QE2 and begin to tighten Fed funds rates, which have been at 0% for over two years.

At the same time, we realize that unwinding QE2 and later raising rates will both inevitably rattle the markets. There are a huge number of investors and pundits who believe that the Fed's easy rates and quantitative easing are the primary reason that the stock market recovered, and that "removing the punch bowl" will remove the only thing that has supported asset prices since the bear market bottom of 2009.

Harvard economist Martin Feldstein published a widely-read article in February entitled "Quantitative Easing and America's Economic Rebound" in which he argued that the Fed's bond purchases induced bondholders to shift their wealth into equities, propping up the stock market and increasing consumer confidence and consumer spending. When this "artificial support for the bond market and equities" comes to an end, he wonders if "we are looking at asset-price bubbles that may come to an end before the year is over."

We disagree that the stock market recovery has been driven primarily by the Fed's "punchbowl." We believe the 2008-2009 recession was induced by a financial panic and that once the accounting rule (mark to market accounting) that helped fuel the panic was removed, the real economy began to recover almost immediately (see "How your view of the crisis of 2008-2009 impacts your understanding of today's big issues"). As the chart above shows, corporate profits have been on a steady rise since then, and have now reached new highs, but not ridiculous new highs. In fact, they are roughly in line with the growth that was rudely interrupted by the crisis on Wall Street.

We have also demonstrated that, although QE2 massively expanded the Fed's balance sheet, the new money available to the banks did not go anywhere, but rather appears to have stayed on the balance sheets of banks as excess reserves held at the Federal Reserve itself (see "Understanding where the banking system is right now").

Therefore, while the stock market may be rattled by the end of QE2 and the eventual tightening of the excessively-easy rates, we believe any negative reaction will be short-lived and that most businesses will be just fine when it happens. These are issues that investors should consider carefully, and which may create opportunities for those who understand the big picture.

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