The Federal Reserve will likely continue its easy-money policy at least through the middle of this year, according to minutes released last week from the Federal Reserve’s Open Market Committee (FOMC) meeting held in March. The stock market, which has been fueled by the easy-money policy known as Quantitative Easing (QE), rallied on the announcement, with the Dow Jones Industrial Average climbing to a new all-time high. Quantitative Easing has kept interest rates near historic lows, which helps stimulate demand for residential mortgages and auto loans. Businesses can also take advantage of low-rate loans to invest in new equipment and hire additional employees. The latter would achieve one of the Fed’s primary goals: reducing the stubbornly high unemployment rate.
Most of the FOMC members agree the bond purchase program ($85 billion per month) is effective in supporting economic expansion, and that the benefits continue to exceed the costs. However, one member, Esther George, reiterated the concern she raised in January. She believes the massive bond buying program provides relatively few benefits and could lead to “financial imbalances, a mispricing of risk, and, over time, higher long-term inflation expectations.” With bond rates near lows, it’s become apparent to us that some investors are shifting funds from conservative investments into more speculative assets simply to capture a higher rate of return. This could set the stage for an unfavorable risk/reward trade-off, not unlike that witnessed during the housing bubble.
A decision to change QE is likely to have significant impact on the stock and bond markets. For this reason, we are closely monitoring and parsing the Fed’s comments and looking for hints provided by economic data, such as the monthly unemployment report. Without giving a date, the Fed has said that it won’t end QE until it sees a “substantial improvement in labor markets.” If the dismal March jobs report is any indication, QE could extend into 2014.