Since 2008, the U.S. Federal Reserve has been providing needed liquidity to the financial system through two rounds of “quantitative easing,” often referred to as QE1 and QE2. The Fed has bought securities from financial institutions, flooding them with the capital they need to make loans. Theoretically, this easing indicates an “accommodative stance” to provide capital for businesses to grow, jobs to be created, and income for people to spend money for goods and services.
Surges in money supply historically have resulted in inflationary pressures three years later. Investors currently concerned about inflation see the Fed’s easy money policy expanding what is called the monetary base—the reserves that commercial banks keep at the Fed.
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This is different from the money supply, which doesn’t expand until the banks actually put those reserves to work by lending capital to people and businesses. The Fed believes inflation cannot occur until the economy spurs enough growth to soak up supply limits.
As consumer spending increases, demand will begin to pressure supply, and companies may feel they can raise prices and wages. Measurement of supply is reflected in what is called capacity utilization. Inflation has a history of rising and falling with capacity utilization. This is what the Fed is talking about when it refers to “slack” in labor and products markets.
Capacity utilization across industries fell slightly in February to 78.7%. This is up 1.2% from last year, but still is 1.6% below its 1972-2011 average. Until the economy grows enough to take up this slack, there is no need to worry about inflation. The Fed will work to keep interest rates low so that money will continue to flow where it is needed.
Simultaneously, the Fed is ever watchful for signs of inflationary pressure as the economy improves. Rather than fuel fears of too much accommodation through a QE3, the Fed took a different tack in late September of 2011. Basically, it implemented a strategy akin to the card game Pontoon, where you either stay put with your current hand or “twist” and draw another card. Hence the name “Operation Twist.”
Here’s how the Fed’s version of Pontoon works. The Fed holds bonds with both short and long maturities in its portfolio. Selling its short maturity bonds and buying longer maturities dries up the supply of longer maturity bonds, driving prices higher and keeping yields lower.
These longer yields are the base rates used to determine the interest rates on mortgage loans, car loans, and other lending rates. Whether that worked well enough to prevent the need for a QE3 has been a recent topic of discussion.
Independent economist Fritz Meyer notes that the market as measured by the S&P 500 index experienced strong rallies after each easing and after Operation Twist was instituted. This showed that the Fed’s actions were interpreted positively by the marketplace. As the effect wore off and the market once again sagged, the Fed would take further accommodative action, inciting another rally in the equities market.
Understanding how the markets interpret Fed statements and leanings, the Fed announced it would begin publishing its interest rate forecasts for overnight loans. It also announced it would make public when it expects the first increase in the interest rates it charges for those loans.
The minutes from its January 24-25 meeting clearly state that the Fed expects to maintain its accommodative stance. And true to its promise, on January 25 the Fed published a chart with projections for Gross Domestic Product (GDP) growth from 2.2% to 2.7% in 2012, from 2.8% to 3.2% in 2013, and from 3.3% to 4% in 2014 with longer-term GDP to average from 2.3% to 2.6%.
The chart also projected a rise in inflation no higher than 2% through 2014. Unemployment is expected to reach 6.7% to 7.6% by the end of 2014 and settle back toward 5.2% to 6% longer term.
The FED’s March 13 meeting minutes did not indicate much change in policy but reiterated its target-interest-rate range of zero to .25%.
With little threat of real inflation in either current economic numbers or the Fed’s projections, the market should interpret the end of accommodative policy as a signal that the economy is on surer footing. It’s also true that interest rates will start to rise. But Meyer states that history shows that competition from higher interest rates with dividend yields on stocks does not necessarily derail the equities markets. He believes this once again will be the case as both the US and global economies begin to heal.