In a previous post (“Quantitative Easing and Substitutionary Atonement”), I discussed some of the underlying philosophy of quantitative easing, the latest of the Fed’s attempts to “stimulate” the economy.
Quantitative easing, to recap, is the term for central bank purchases of assets on the open market.
The difference with traditional “open-market operations” is twofold.
Firstly, the purpose: open-market operations normally have interest-rate manipulation as their goal. The Fed maintains what is called the federal funds rate, which is the interest rate (yield) the Fed targets in buying and selling short-term treasury paper, the most liquid asset on the money market. This sets a floor for interest rates generally. Quantitative easing, on the other hand, is not conducted to manipulate interest rates. Rather, it is conducted to amplify the money supply in the financial market, and in this manner to affect asset prices.
Quantitative easing comes into play when interest-rate manipulation has run its course — such as when interest rates have already been lowered to zero or near-zero, in which case those efforts come to resemble pushing on a string.
Secondly, and in line with the purpose, the quantity involved: as can be seen on the accompanying graph, quantitative easing involves a massive increase in asset purchases as compared with standard open-market operations. The latter were in operation prior to the credit crisis of 2008, and the asset level was stable at around $900 billion, reflecting the fact that buying and selling were conducted interchangeably. The former was initiated soon thereafter, as can be seen from the explosion in asset holdings. In the meantime, it has stabilized at $4.5 trillion (!).
What has been the effect of this? Well, as my previous post explained, it has simply increased the money circulating within the financial market. By contrast, it has done nothing to stimulate the ordinary market. This disconnect between the two markets is explained further in our course in economics, which outlines the relationship between these markets.
Now let’s juxtapose the Fed’s balance sheet with the Dow Jones Industrial Average, this time updated to March 2016:
The correlation still seems to hold true. The Fed has not added to its holdings since late 2014, and the DJIA has been unable to break through the ceiling that inaction has formed. Whether or not the correlation is a direct one, or whether there is any real relationship between the two, is more a matter of theoretical plausibility than practical proof, but it would certainly seem that there is some causal relationship.
Assuming that there is such a relation, this would also indicate where the stock market is headed once the assets start being reduced, either by being sold or by being retired. This will take money out of the financial market, causing prices to drop. This in turn might lead investors to take out their own money, precipitating what could become a rout.