For months the market has waited anxiously for the Federal Reserve’s decision about “tapering” its stimulus program of large-scale bond buying, which has become known as Quantitative Easing (QE). Many investors believe the program is propping up financial markets. Indeed, as this graphic from the Financial Times shows, the performance of the S&P 500 closely tracks the growth in the Federal Reserve’s balance sheet as it has increased its purchasing of bonds to the pace of $85 billion per month:
Investors fear that withdrawing QE could lead to a great deal of uncertainty and maybe a sharp market correction.
On Wednesday it finally happened. Outgoing Federal Reserve Chairman Ben Bernanke announced he would scale back asset purchases by $10 billion, to $75 billion per month. But the market rallied even more. After the announcement, the Dow Jones Industrial Average closed up 292.71 points, or 1.8%, a new high for the year.
The reason why the market surged after the announcement is that the so-called taper was really a reaffirmation of extremely easy money and stimulus. If an alcoholic decides to get drunk a little less quickly this weekend than last weekend, we wouldn’t say that he’s sobering up; neither should we say that the Federal Reserve is ending its stimulus program.
Today the Wall Street Journal points out that the Fed “bought about 90% of new, eligible mortgage-bond issuance in November, up from roughly two-thirds of such bonds earlier this year.” Thus even though there is going to be a modest $5 billion reduction in the amount of mortgage-backed securities (MBS) bought by the Fed (with the other $5 billion reduction coming from Treasury and government agency bonds), the Fed is still going to be buying a bigger proportion of MBS issuance than ever, because issuance has slowed so much since the earlier bout of taper talk halted the mortgage refinancing boom with a jump in interest rates. So the Fed pretty much had to taper mortgage purchases, because there weren’t any more mortgages for it to buy.
So maybe the Fed’s decision on Wednesday will prove to be the point when the ocean liner of US monetary policy began gradually to turn away from easy money. But given that the Fed explicitly stated that “asset purchases are not on a preset course,” maybe not. The Fed has increased QE in response to short-term market dips before. Now that it seems to be in the game of trying to engineer permanent and uninterrupted growth, the real test of Fed policy will come next time the market seriously corrects, when we’ll see whether our central bankers can resist turning on the spigots again.
Matthew B. O’Brien, Ph.D.