Question

Fed policy makers announced that October 2014 would conclude their third round of using dollars to buy vast sums of bonds — $1.7 trillion in just the third round of the program, known across the land (or at least the financial world) as QE3.

The idea of increasing the money supply was to keep the economy moving closer to equilibrium in the aggregate and keep interest rates low to spur investment and lower unemployment. We have seen unemployment trend downward since the peak in 2010 and GDP growing in real terms since 2010. However, there are many thoughts as to the actions of the Fed on the overall economy in the long term; both positive and negative. In addition, the Fed has increased interest rates to tighten the money supply as unemployment as dipped below 5%. You can see a history of the Fed Funds Rate by clicking here. The Fed has also started to reduce its balance sheet through its Balance Sheet Normalization process (click here for Fed Press Release). You can also see the trend of the Federal Reserve’s balance sheet by clicking here.

You are to develop an opinion on the Feds actions in the past to use unprecedented monetary policy (the buying of bonds by the Fed Open Market Committee) and to now stop the program now and raise interest rates. Do you think the actions of the Fed were warranted during the recession? Were the actions too great or too little? What do you think will happen to the economy going forward (interest rates, unemployment, growth, Federal debt levels, etc.). Do you think it is time for the Fed to continue to increase interest rates and Balance Sheet Normalization?

Answer 1

Federal Reserve officials took bold steps to battle the financial crisis and the Great Recession, none more audacious than purchasing trillions of dollars in bonds in an unprecedented and politically charged attempt to boost economic growth.

Now, with the economy healthier — and mixed opinions about how much the bond purchases actually helped — the Fed is preparing to scale back its massive stock of about $4.5 trillion in assets.

Those holdings of mostly Treasury bonds and mortgage-backed securities are more than quadruple what they were before the crisis, and reducing them is another risky move that could affect mortgage rates, consumer prices, bank lending, stock values and federal government borrowing.

But there’s also risk to standing pat. Like any investor, the central bank could suffer losses on the bonds if it holds them too long and interest rates rise. At the same time, holding a lot of assets could make it harder to buy more if that’s needed to fight a future recession.

So Fed policymakers plan to start trimming their holdings this year. They hope to do it gradually and seamlessly, without the controversy and fanfare that has made the once-boring institution a political target and shaker of financial markets.

“We think this is a workable plan and it will be … like watching paint dry,” Fed Chairwoman Janet L. Yellen said last month in detailing a methodical sell-off of some of the assets on the bank’s balance sheet. “This will just be something that runs quietly in the background.”

That wasn’t the case in 2013.

Then-Fed Chairman Ben S. Bernanke’s suggestion that the central bank would begin a tapering of its ongoing asset purchases surprised investors. His comments caused stock prices to drop and bond yields to spike in a volatile global market reaction known as the “taper tantrum.”

Fed officials learned from that experience. This time, they have carefully signaled their plans in recent weeks and have promised to proceed cautiously to avoid spooking investors and harming the economic recovery as well as their own credibility.

“They’re trying to make as little impact as possible on the markets,” said Jack Ablin, chief investment officer of BMO Private Bank in Chicago. “By moving in a very incremental fashion and telegraphing their intentions, they hope investors will allow them to execute the program without much turbulence.”

But there’s uncertainty about how the unwinding scheme will play out.

While the bond purchases never set off wildfires of inflation, as many critics warned they would, economists and financial analysts remain divided about how much economic stimulus was provided. And there’s little agreement on how much of the money the Fed created to buy the bonds should be kept in the financial system.