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The Unease over Quantitative Easing

APR 25, 2014 12:40pm ET
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There are increasing voices in and out of the Federal Reserve proclaiming the need for more inflation in order to pull the U.S. economy out of its current, sluggish growth cycle. This is the state of affairs six years after the 2008 global financial crisis, which was rooted in a massive real estate bubble and caused the greatest recession in almost a century.

The question that remains is whether after six years of accommodative monetary policy, the Fed should maintain such policies in order to increase inflation, and how they may impact the housing and mortgage markets.

In the wake of the 2008 global financial crisis, the Fed began an accommodative monetary policy that continues to this day. After lowering interest rates to zero, the Fed instituted a bond buying program that resulted in a groundbreaking effort to boost the flagging U.S. economy.

The rationale was simple: as private demand had not risen back to pre-recessionary levels, the Fed would step in and stimulate the economy by purchasing financial assets—including mortgage-backed securities—and quadrupling its assets in six short years.

At the onset of this unconventional method, known as quantitative easing, many commentators decried the effort as the first step to runaway inflation. When this inflation did not materialize, the stories began to disappear from the front pages of newspapers, and the focus shifted to the Fed "printing money."

That meme is inaccurate as well. The Fed’s QE program is far from printing money. In fact, the Fed is actually creating demand through the purchase of bonds, thus allowing the banks to create more loans.

So, why has the QE program been necessary? One overlooked economic indicator, the output gap, holds the answer. Basically, it is the difference between the gross domestic product at its full, efficient capacity and the actual GDP of the country.

When the output gap is positive, the economy is growing faster than its full capacity, giving rise to inflationary concerns. This gives the Fed reason to increase interest rates in order to exert downward pressure on growth in the economy.

When the output gap is negative, the Fed—depending on other conditions in the economy—may intervene through an accommodative monetary policy that encourages jobs growth, and more lending.

Following the 2008 global financial crisis, the U.S. economy has experienced the largest, longest negative output gap since 1950. In fact, even though the recession has ended, the negative output gap continues and the economy in the United States will not return to its full potential until late in this decade.

The Fed's rationale for beginning, and continuing, the series of QE's has been to ensure that the current recovery maintains its momentum, and that the economy does not fall back into a recession. In essence, the Fed has acknowledged that there was insufficient private demand to help the economy grow. As a result, it chose to continue a monetary policy that was accommodative and helped buffer the economy until private demand began to rise. The reason the Fed has begun to wind down its QE program is that the economy is well on its way to sustained growth.

However, the output gap, which has been negative and will remain that way for a few years, will continue to allow the Fed to maintain its accommodative policy by maintaining low interest rates, even when the QE program has wound down.

The impact of winding down QE on the mortgage markets may already have been absorbed, through the rate increases of the past year. The latest refinancing boom has slowed to a crawl. However, as the real estate market returns to equilibrium, purchase mortgage levels will normalize as well.  There has been much written about the ability of the housing market to absorb higher interest rates.

While many believe in the prognostication of specific rates, that practice is neither realistic nor fair to the markets.

There are, however, three points worth noting when considering interest rates and the mortgage markets. First, the U.S. economy is recovering from the worst financial crisis in a century. The fact that it did not sink into a depression was due to the robust monetary policies of the Federal Reserve.

Second, the Fed has been very transparent about its future policy direction and continues to maintain an accommodative tone.

Third, mortgage rates remain at historic lows, waiting for the real estate market, and the economy as a whole, to recover.

That will not happen until we are able to close the output gap, and see our economy performing at its full potential.

Behzad Gohari is an attorney, entrepreneur and investor and currently serves as managing director at The Althing Group, an advisory firm in Washington.

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