Throughout 2013, many economists wondered if the Federal Reserve was waiting too long to begin “tapering” the third round of Quantitative Easing. As a quick reminder, the Fed has a dual mandate to encourage “full” employment…generally having the unemployment rate at or below 5%. The Fed is also expected to keep inflation at or below 3%. Keynesian Economic Theory holds that if the economy is slow, the Fed can reduce the rate it charges member banks, so that they will reduce what they charge consumers. For almost five years, the Fed Funds rate has been zero, and can’t go negative. The hope is that if interest rates are low, businesses and consumers will be more likely to borrow and spend, which should stimulate economic growth. However, too much growth, can lead to unacceptable inflation.
The second “lever” that the Fed can use to stimulate the economy is to increase the money supply. In buying bonds, the Fed removes bonds from bank balance sheets, and replaces them with cash. Since banks don’t make money on cash, they should theoretically want to lend more money. However, as banks have struggled to understand all the new requirements stated and implied by the Dodd-Frank Act, and the agreements from the Basel III Accords, they have been very reluctant to lend out that cash. All of this “stimulus”, QE1, QE2, QE3, TARP, TALF and the $757 Billion Stimulus Package proposed by George Bush and signed by Barack Obama has grown the Federal Balance sheet to almost $4Billion. QE3 has continued adding $85 Billion per month to that balance sheet. With the announcement yesterday, the Fed is “tapering” that to only $75 Billion per month. When Chairman Bernanke hinted at the policy change in June, bond funds and dividend-rich stocks plunged in value. Yesterday, the Dow rose almost 300 points after the announcement, so it seems that the announcement was already “priced in” by investors. The next time the Federal Open Market Committee meets, the new Chairman will likely be Janet Yellen. The action yesterday signals what we hope is the beginning of the end of the need for extraordinary intervention by the Federal Reserve as the economy continues to slowly recover from the shock of 2008, and also makes the transition easier for Chairman-designate Yellen.