With respect to present-day economic stimulus, think of the Federal Reserve as a gigantic, 21st century Pac Man on financial steroids.
Most of us remember that game, don’t we? It was from a simpler era, with Pac Man guided by joystick down two-dimensional walkways, avoiding Blinky, Pinky, Inky and Clyde while eating up a screen full of pac-dots. Pac Man could turn cannibalistic as necessary by gobbling up a limited number of power pills. The goal was simple: Keep eating dots.
Over the past six years, it’s been the Federal Reserve that’s been eating insatiably. Instead of dots, however, bonds have been on the menu. Why has the Fed purchased so many bonds, and how has this behavior affected the economy?
The U-Shaped Economic Recovery
There is no question that the Federal Reserve’s bare knuckles fight against the Great Recession and subsequent economic malaise has been long and arduous.
After all, just about every previous recovery — even the one following the Great Depression — experienced a boomerang-effect of strong growth relatively quickly after the downturns were over, creating essentially a V-shape when charted on a graph.
This time around, we’ve seen a grinding, frustratingly slow U-shaped recovery. Only recently did a hint of possibly accelerating growth occur after the Commerce Department announced second quarter growth as a solid 4% on an annualized basis. On the other hand, the first quarter declined by an annualized -2.1%, causing many to argue we’re still on an economic treadmill.
In an effort to drive down interest rates in order to stimulate borrowing and thus demand for goods and services as a whole, the Fed pumped over three trillion dollars into the economy between 2008 and the end of 2013. How did it do so?
The Federal Reserve’s Aggressive Bond Purchases Ballooned Its Balance Sheet
Beginning in 2008, the Federal Reserve began a calculated, aggressive program to purchase bonds and other similar debt instruments. At the time, it owned just over $1 trillion of assets, and accomplished the $3 trillion of purchases over the next five years by simply printing more money, then purchasing bonds.
In short order, the Federal Reserve’s balance sheet — assets, liabilities and equity as measured at a single point in time — quadrupled in size.
The Relationship Between Bond Prices and Interest Rates
Investopedia discusses the inverse relationship between bond prices and interest rates as follows:
Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn’t be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond’s price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).
The principle also works in reverse. As money floods into the bond market, the prices of bonds (like any asset class when demand increases) rise. Thus, interest rates fall. This is precisely what happened shortly after the economy started teetering in 2008 and in the immediate aftermath of the financial crisis that followed.
Interest Rates Fell to Record Lows
Clearly, the Fed’s efforts worked. As per the chart on the right, the downward trend starting in late 2007 accelerated in 2008 after the Federal Reserve began its asset acquisition program, which resulted in increasing bond prices and as explained above, lower interest rates.
It didn’t stop there. Quantitative Easing began in earnest, with the first round starting in November, 2008. In August of 2010, another $600 billion of Treasury instruments were purchased. Finally, in September, 2012, a third round was initiated, QE3, which has seen as much as $85 billion of bonds purchased each month.
This year, the Federal Reserve began tapering its stimulus, with the goal of ultimately ending bond purchases once the economy had strengthened sufficiently.
Has the Economy Benefited From Aggressive Fed Intervention?
That, of course, is the trillion-dollar question.
Many argue that the Federal Reserve saved the economy by forestalling another Great Depression. Others call that a conflated argument – as up until the Federal Reserve began regularly employing aggressive monetary policy to combat economic downturns, depressions were relatively commonplace in the United States, occurring roughly every 25 years between 1807 and 1930. Furthermore, Fed policies have led to economic growth since the end of the recession, but at a subnormal pace.
The truth is probably somewhere in the middle. There is ample evidence that a depression was in fact avoided due to Fed intervention. However, although there is no specific downside to the Federal Reserve’s balance sheet expanding, the increased money supply from its purchases of debt instruments — a calculated effort to lower interest rates and spur lending, as mentioned above — has the potential to cause substantial inflationary pressure.
In order for inflation to not accelerate (and assuming velocity remains constant), output needs to expand at the same pace as the money supply. In these times of below-average growth, that doesn’t seem terribly likely.
The Next 12 Months Will Be Key
Former Chairman Ben Bernanke once asked rhetorically, “How much would you pay to avoid a second Depression?” We already know the Fed’s answer: $3 trillion. With interest rates likely on the rise next year, we should soon see whether or not it was all worth it.
If not, fear not. Pac Man makes for an excellent diversion on your iPhone while you stand in the unemployment line.
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