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Email not displaying correctly? View it in your browser. The Impact of the End of Quantitative Easing By Laura Alspaugh - P-Solve The Federal Reserve Open Market Committee (FOMC) formally announced on October 29th that quantitative easing (QE) is over. The Committee expects that economic activity should expand at a moderate pace and also cites its statutory dual mandate of fostering both maximum employment and price stability as the reasoning for ending QE. In this article we will review what quantitative easing is, how it has impacted the markets and the economy over the past several years, and what impact that has on pension plan sponsors. QE is the purchase of assets in the market, such as long-term bonds, with newlycreated money. This has the effect of increasing the size of the central bank’s balance sheet and of reducing the supply of the asset being purchased (reducing its yield). The newly-created money is meant to end up in banks to be lent out, sparking increased economic activity. QE is an unconventional monetary policy tool. Normally, the Federal Reserve Bank uses the level of short term interest rates to influence economic activity, specifically the Fed funds rate which is the rate at which banks can lend and borrow from each other. Maintaining a lower Fed funds rate is intended to spur borrowing and give a boost to economic activity through increased bank lending. Raising the rate can slow growth and is used when inflation expectations are higher than the Fed would like. Among economists, there is plenty of debate as to whether or not the Fed’s policy of quantitative easing has been a primary driver of the US economic recovery. There is no way to truly know how things would have turned out without the use of this unconventional monetary tool but it is a great topic for debate involving political and socio economic factors. The Fed’s Statutory Mandate As the economy contracted after the financial crisis, the Fed maintained very low Fed funds rates (essentially zero) and then employed QE to purchase bonds to increase the amount of money in circulation. The goal was to stimulate economic activity which would in turn reduce the unemployment rate and also to keep inflation at comfortable levels (deflation is something the Fed is very worried about). Low interest rates also likely contributed to the strong stock market performance that continues as of this writing. By increasing the money supply through QE and by maintaining near-zero interest rates for many years, many economists and investment experts believed that high inflation would be the result. That prediction has not materialized. Commodity prices have fallen, and wage growth has remained muted. It is difficult for inflation to take hold without either commodity prices or wages, or both, rising quickly. A contraction in the labor supply may herald potential inflation in the future. However as of today, the labor market has capacity and other inflation drivers are not evident. The Interest Rate Environment The Fed has indicated that it will start raising the Fed funds interest rate as early as 2015. Many believe that this will inevitably lead to higher interest rates at all bond maturities and have positioned their investments accordingly. However, while in late 2013 we saw an uptick in rates, the reality is that rates have remained low and have fallen for most maturities throughout 2014. With other countries’ interest rates lower than the US, the US bond market is attracting money, which helps to hold rates down. Also, pension plans continue to seek fixed income investments as part of their investment strategy in managing the plans’ assets and liabilities. While higher short term interest rates could lead to higher long-term interest rates in the future, it is difficult to predict when this might happen and how much long-term rates might rise by. Much depends on the market’s outlook for future inflation: if it remains low, rates will remain low and if not they should rise. The Stock Market The US stock market has benefited from the Fed’s low interest rate policy. With the Fed’s continued commitment to low rates and quantitative easing over the past several years, the market’s reaction was positive. The Fed started hinting that it would reduce and end its QE program, and potentially raise interest rates in May 2013, leading to a sharp market decline. This process of winding down QE was referred to as “tapering”. Clearly the markets were telling the Fed that it was too soon to taper. Ultimately, the economic data began to improve to a point at which the markets appear to have accepted the end of QE without melting down. Without the support of QE, markets should need strong earnings growth and improving economic conditions to continue to move higher. These indicators are positive, for the most part, today. Risks to stocks include continued economic and political troubles in Europe and in some emerging economies. The world economy is interconnected and the US cannot always perform well on its own, though right now the US is possibly better positioned than most of the rest of the world economies. The markets typically are a leading indicator. If that is true, one might argue that the US stock market’s new highs are predicting continued economic improvement and higher GDP. Pension Plan Strategies We have advocated for a long time that matching liabilities with assets of similar interest rate sensitivity (fixed income duration) will reduce Plan funding level volatility. Despite low rates, there is still room to de-risk a pension plan. The more a Plan’s liabilities are matched with fixed income assets, the less impact the equity market will have on the Plans’ funding levels. Long-term fixed income also yields significantly more than short-term fixed income. Holding long-term fixed income in place of traditional short-term fixed income as part of a balanced portfolio means that non-fixed income assets, such as equities, don’t need to work as hard. Rates may continue to be low for some time, so we recommend that Plans continue to de-risk and take steps to lock in gains when they occur. If funding has improved, seek to lock down that improvement by increasing the amount committed to matching liabilities with a liability matching strategy. forward to a colleague Copyright © 2014 P-Solve, All rights reserved. Our mailing address is: P-Solve 200 West Street Waltham, MA 02451 Add us to your address book unsubscribe from this list | update subscription preferences