The market has been very keyed in on two little of letters recently, QE, Quantitative Easing.
But what exactly is quantitative easing, and is it as positive as investors think it is?
Joining me today for a little Q&A on QE is Morningstar's Bob Johnson, director of economic analysis.
Thanks for joining me, Bob.
Now with quantitative easing, they're going a little further because already the short-term rates are close to zero, so they can't reduce those any further. So now, they're trying to directly influence longer-term rates and bring those down as well. So what they will do is go out and purchase longer-term Treasury instruments, and by buying those, they'll make the price of those instruments go up and that makes the interest rate go down, and so that's what they're really trying to achieve here, is driving interest rates down more directly.
On the corporate side, it reduces interest expenses as people refinance their bonds at lower rates, and so earnings go up. And probably the most important thing it does on all assets: [assets] are usually valued at something like a stream of earnings over many years, and then you discount them back to a current rate. You apply an interest rate to those to kind of equate it to current-day terms. And if you're reducing long-term interest rates, you're making a substantial change in that number, and by doing that--if people believe they are long-term sustainable--you are increasing the value of those assets, such as the stock market.
Stipp: So the stocks would potentially go up because that discount rate is lower.
Johnson: That's right. If people believe it's a long-term sustainable number not just a short-term manipulation.
Stipp: Now on the other side of the coin, there's a lot of talk about the low-yield environment, that you can't find a good interest rate on anything these days. There seems to be some cons to lower interest rates. What are the negatives that we've seen because of these policies?
Johnson: One of the things that we've seen a lot lately in the real income numbers, which I look at every month to determine how much consumers can spend. One of the big negatives has been dividend and interest income have been declining sharply every month that I look at the numbers. Wages have started to act a little better, but the interest numbers are starting to really sag, and hurt the numbers. So, that's probably the number one effect.
Number two is, lower interest rates, historically, have a track record of helping corporations who are generally pretty eager to put money to work, and then taking out of savers' hands, who obviously aren't spending the money; so, it moves money from the savers to spenders.
And this time around corporations are the one sitting on their hands. We're seeing the cash balances accumulate and unwillingness to invest. And I'm thinking that lower rates have actually hurt consumer spending because it's taking money away from a spending part of the economy, and the corporations are sitting on the money.
Stipp: So maybe if rates have been a little bit higher, retirees would have more interest income, they might be more likely to spend that money out into the economy than corporations seem to be, because the lower rates should spur corporations to spend, but they're not.
Johnson: Right. And certainly, you talk about things that are bad about QE, obviously, it can create more asset bubbles. Every time we've brought rates this low before, it's created a bubble. In 2000s, it was some of the tech-related things. Now it was housing in the last cycle. Maybe this time its emerging markets, I don't know. But when you tend to create all this cash and there isn't a willingness to spend it right away here on the real economy, what else can that money do? Well, it tends to move into speculative hands, and that's where the real danger is.
Stipp: It's looking for higher rates basically.
Johnson: Yes.
Stipp: So I guess the question then is, is this quantitative easing, is it really helping the economy or is it just kind of helping the stock market, or is it helping the economy by helping the stock market? It seems like the direct effect is to raise asset prices, but that might not always translate into real growth.
Johnson: Yes. I think that's what the Fed is gambling on right now, and why some of the Fed members have said we're dealing with the devil here. We take a shot at having a speculative bubble, but the goal is, hopefully, if we start to move up our asset values a little bit, that certainly the people that have assets will tend to spend some of that asset value increase. It's not a lot, but 3% to 5% of asset value increases tend to flow back into consumer spending pretty quickly. And so, I think there is some hope that as asset values move up, especially right here in front of the holiday season--Happy Holidays--that it will certainly start to move things in the right direction if asset values are going up.
Stipp: So, it's the so-called wealth effect then.
Johnson: That's the wealth effect, and so that's I think a good part of what we're banking on.
Stipp: But the other question, though, Bob is, rates are already pretty low and so for something like the housing market, if the rates tick down a little bit, do they really think that that's going to spur people to go out and spend or buy a house when they haven't done it so far when rates were at historical lows?
Johnson: I think housing is almost at record affordability right now, and really, I'm not a big fan of quantitative easing to be honest with you, Jason. I mean I think it is going to tend to blow a bubble here, and it's going to create a situation where every time there is a little slippage in the economy, we expect the Fed to ride to the rescue and with some new wild program, and I think the economy just needs to sit back and adjust a little bit. Maybe we need a jobs program here; maybe we need some targeted infrastructure spending, but this idea of using another asset bubble to reflate the economy just seems a little silly to me.
Stipp: So Bob sort of circling back then to how the market has been reacting to the news on quantitative easing. On Wednesday, it seemed like the market was disappointed because it looks like the quantitative easing the Fed is going to announce next week is going to be more modest than some people had thought. What are your thoughts on the size of the quantitative easing and the possible effects there?
Johnson: Sure. I think that the last time this program went into effect, we did $1.7 trillion worth of easing, and that was in '09 when the markets were really kind of falling apart, and they did it in a very short period of time. And in the short term, it was helpful to the markets. It was kind of a shock-and-awe; it's a big number. The U.S. bond market externally held debts, $9 trillion, so that was a big piece of money.
Now the rumors are, the number that got floated on Wednesday that people found a little disappointing, was they're talking $250 billion, but they're talking maybe for two or three quarters, and then it will reevaluate, maybe it does become a bigger number, but they aren't going to do the shock-and-awe, let's do the $1.7 trillion all in one slug, and I think that's what spooked the market a little bit.
And frankly, I think the go-slow approach is better, but I think the market was hoping--from guessing from the giant moves we've seen in interest rates and commodities, that they were really expecting something a little bit bigger.
Stipp: Very well, Bob. Well, thanks for clearing up all the questions about quantitative easing and its possible effects. Thanks for joining me.
Johnson: Great to be here.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
