Should Reversing QE Come Before Raising Interest Rates?

As the economy improves changes in Fed policy is likely but what action the Reserve will take is open to debate. The question was proposed by Tim Worstall in an article entitled, Should The Fed Raise Interest Rates Or Reverse QE First? It is an important one as policy makers decide what they are going to do with this long-term debt while still trying to support America's re-emergence.

It should be remembered that the purpose of QE was to stabilize the banking system that found itself without capital reserve not too long ago. As a crisis aversion tool the goal was to increase government debt through the buying of securities thereby putting more electronic cash, hence reserves, into the banks to avoid major defaults that could have dragged the economy down.  It became a crisis averted by transferring risks from the private sector to the government.

As a policy stabilization made sense during a bank crisis but makes less sense as the economy recovers. The need to keep the liquidity of money flowing throughout the economy has dissipated and QE has stopped. According to the Heritage Foundation debt moved from $870 billion to $4.4 trillion in 2014. The nation must now deal with this debt and find ways of pushing it back into the private sector.

Sustained debt has an increasing risks to a nation that seeks to enhance its economic position. As debt levels rise, the cost of servicing that debt also increases which has an impact on growth rates (Turner & Spinelli, 2012). In comparison, European nations have experienced a flatter growth rate due to unsustainable debt levels. Maintaining such high debt  not only causes a drag on the economy but also increase risks of impotence when and if future crisis occur. 

Higher amounts of debt ratios, as a percentage of Gross Domestic Product, eventually raises interest rates (Hsing, 2010). Higher T-bill rates also caused inflation to move upwards over the long run. Debt levels, interest rates, and inflation seem to have a connection that creates the right framework for economic growth. 

Raising interest rates helps fight against inflation. By making money less available the government can ensure that growth stays within its target rate and doesn't heat up too quickly. By returning the debt back to the private sector it will fight against inflation by soaking up extra electronic currency that stimulates short-term demand.

Instead of officially raising interest rates it may be better to start unloading the debt in adjustable chunks giving the Federal reserve an opportunity to gauge the economy and its momentum at each stage. This will give more control to the government, raise interest rates, and work toward better debt management processes. Moving debt off of the balance sheet may just help us out in the future if another economic crisis rears its ugly head.

Hsing, Y. (2010). Government debt and long-term interest rate: application of an extended open-economy loanable funds model in Poland. Managing Global Transitions, 8 (3).

Turner, D. & Spinelli, F. (2012). Interest-rate-growth differentials and government debt dynamics. OECD Journal: Economic Studies.

Feds Announce the End to the Era of Quantitative Easing

The Federal Reserve announced a discontinuing of the controversial bond buying program at the end of October this year. They will keep the short-term rates around 0 for the near future.  To this point, the risk to inflation is relatively low and the economy has shown mixed signals of strength in the last year or so. The Federal Reserve seeks to support the  3% projected national growth rate while not undercutting gains in the employment market. 

Lower Unemployment and Skepticism: 

Unemployment dropped to 5.9% but wages have not risen to provide an income boost. Most Americans are still skeptical of the economy and feel that improvements will occur sometime next year. They are not sure when next year but “sometime” seems to be the target spot. It is skepticism that is a result of not seeing high paying jobs and wage increases.

Bond Purchases: 

The bond purchases were controversial from the beginning but were seen as one avenue of encouraging development out of the world’s longest recession. Since 2008, the Fed’s investment holdings are around $4.5 trillion making them unprecedented in history. As the amount rises, so does the cost of debt, at a time where budgets are anything but balanced. 

The whole purpose of quantitative easing was to reduce interest rates to spur borrowing and improve economic activity (Newman, 2013). Theoretically, as interest rates decline businesses find it cheaper to expand operations and build more factories and businesses. It ignores the high rates of cash many of these businesses are sitting upon. 

As debt increases so does its overall costs. It becomes counter-intuitive to hold so much debt without reasonable assurance when and how it will be paid back. Long-term liabilities in business and government can be risky if the situation changes, another recession occurs, or the costs of servicing that debt rise unexpectedly. The Fed has ended an era of Keynesian induced development. 

Low Interest Rates: 

Keeping the interest rates low at a time when inflation risks are low is beneficial. Low interest rates can be a spark for development and investment (Dunlap, 2013). That development can be in the form of business growth, housing, or spending. As money stays cheap people will naturally spend more because it is easier for them to borrow than to save. 

Economic Optimism:

One factor that is not discussed in all the high finance terminology is optimism. American businesses must feel as though their future prospects will be lucrative. Investors want to feel that by borrowing and spending today they will reap significant rewards tomorrow.  Their analysis and decision-making leads to the conclusion that the economy will continue to get better and expand leaving them ample room for profit. If they perceive the economy will not get much better it makes more sense to purchase less risky investments or hold their money in the bank until brighter days are again apparent. 

Newman, R. (2013). A boost from the Fed. U.S. News Digital Weekly, 5 (10). 

Dunlap, N. (2013). Interest rates, the economy, and the market marionette. Journal of Property Management, 78 (6).