How does quantitative easing affect the economy and the investment outlook? Find out and you will be putting valuable strategies into your investing tool kit
Recently, I’ve mentioned that the world is going through a gigantic monetary experiment. At first, I was referring to the “quantitative easing” that the U.S. Federal Reserve and other central banks began in 2008/2009, to offset the financial crisis. But the more I look at it, the more I see a process that’s been going on for a century.
So how does quantitative easing affect the economy and your investment decisions? Here’s our view:
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How does quantitative easing affect the economy for investors? The answer starts with understanding the history of the gold market
In 1971, French demand for U.S. gold helped spur U.S. President Richard Nixon to “close the gold window”—stop redeeming U.S. dollars in gold. From then on, trading in foreign-exchange markets determined the value of currencies. They rose, or fell, mostly on their own, but sometimes with intervention by one or more governments.
Today, the gold standard is not in use by any government. Now the entire world runs on a fiat-money standard, which is exactly what it sounds like. Unlike gold, which has value because people want it, fiat money has value because a government has issued a “fiat”—an edict or decree—that says it has value and is “legal tender.”
After 1971, the next big monetary shock came during the financial crisis in 2008/2009, when central bankers added “quantitative easing” to their toolkit. That’s the central-bank tactic of buying government bonds, or private-sector financial assets, such as stocks and bonds, to inject new money into the economy.
This differs from the earlier tool, “open-market operations,” under which central banks buy and sell short-term government obligations such as T-bills. This has an impact only on short-term interest rates. Quantitative easing has lowered long-term rates.
Quantitative easing also took the fiat-money standard into a whole new dimension. It has led to the lowest interest rates in all of recorded history.
How does quantitative easing affect the economy for investors in relation to the 2008/2009 financial crisis?
The 2008/2009 financial crisis was the world’s worst financial upset since the 1930s. So, governments and central banks around the world took extraordinary measures to halt the damage and spur a rebound in the economy and stock market.
In the U.S., the outgoing Bush and incoming Obama administrations turned on the deficit-spending tap. They began a series of yearly federal budget deficits that were unprecedented in peacetime. Other countries followed.
Meanwhile, the U.S. Federal Reserve and other central banks began a program of monetary economic stimulus that has come to be called “quantitative easing.” That is, they began buying financial assets—mainly government bonds, but also mortgage debt and corporate securities—every year for each of the past six years. Their asset buying was equal to 1% to 3% of world economic output each year.
This dovetailed nicely with the deficit spending. To finance its budget deficit, the government ordinarily borrows money by selling bonds. This tends to push interest rates up, which can prolong a crisis, or even set off a deeper recession. To counter that risk, the Federal Reserve and other central banks bought long-term government bonds, to hold long-term interest rates down, and gradually drive them lower.
The central banks paid for these asset purchases by simply expanding their own credit. It’s all done electronically, of course. But it’s the modern equivalent of just printing the money.
In other countries and other times, excess money-printing has sparked high levels of inflation. When money-printing really gets out of hand, it can lead to hyperinflation. This virtually destroys the value of the local currency. It mostly happens following a war and/or in countries with inept or corrupt governments.
Here’s how deficit spending/quantitative easing affects interest rates and inflation
After the financial crisis, the deficit spending/quantitative easing combo did a good job of holding down inflation. During the Obama years (January 2009 through January 2017), U.S. inflation averaged less than 2% a year. That’s roughly half the level of the previous couple of decades, and less than a quarter of the peaks of the 1970s and 1980s.
However, during those years of mild inflation, the U.S. economy stumbled along at half the normal post-recession growth rate of the previous half-century. This weak growth was partly a result of low interest rates.
So, despite near-giveaway interest-rate levels, businesses scrapped some growth plans. Instead of making capital expenditures for growth, they devoted excess funds to paying dividends, buying back their own stock, and/or making acquisitions. As a result, economic growth suffered.
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What if anything do you think could have been done differently to help the economy recover from the 2008/2009 financial crisis?
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