Market Outlook | Fall 2014
When Ben Bernanke began the process of bringing the Federal Funds rate to essentially 0%, the stated goal of the Federal Reserve Bank (Fed) was to stabilize the economy and bring unemployment to 6%. The Fed also launched an unprecedented quantitative easing program (QE) to patch up the financial system and get the economy growing again.
The initial asset purchases (QE1) by the Fed were followed by more buys several times in 2009. When the economy failed to respond adequately by October 2010, the Fed upped the ante with QE2. This process of buying US treasury bonds was thought to lower long term US interest rates. The Fed believed that these lower rates would encourage businesses to borrow, grow, and hire more employees. QE3 followed shortly after.
The Federal Reserve announced this year that they will conclude their policy of quantitative easing in October. Ironically interest rates for long term US treasury bonds will likely remain low after the Fed stops buying them. The European Central Bank (ECB) has adopted their own accommodative monetary policy (lower interest rates) and their own version of QE. German government bonds now yield 1.04% for 10 years, Italy is at 2.37% and Spain is at 2.2%. Overseas investors are tempted to pick up some good old US treasuries at 2.42%, especially when the dollar is likely to strengthen now that the Fed is stopping QE.
Historically the Fed has simply withdrawn bank reserves (reduced the supply of money) to increase the federal funds interest rate to slow the economy and control inflation. This time, the Fed plans to target money market mutual funds and other non-bank financial instruments. The Fed will set a federal funds range from zero to 0.25% and then use overnight reverse repo agreements to set the lower boundary of that range.
Regardless of the strategy, the result will likely be the same according to Fed minutes. Low rates for a prolonged period of time.