The U.S. economy has made an extraordinary comeback from its early 2020 lows. And while there is still some room for improvement, the economy has made enough progress that the Federal Reserve feels comfortable dialing back some of its emergency monetary policy efforts.
This means you’re about to see a ton of mind-numbing headlines about the Fed and monetary policy and the “tapering” of quantitative easing (QE).
This is incredibly important stuff, but it’s easy to get lost in the jargon and/or the nit-picking that often comes from Fed’s many vocal critics.
The bottom line is that we’re only talking about this because over the past year and a half, the economy has indeed made an incredible recovery. And now the doctors at the Fed are beginning to remove the monetary ventilator so that the economy can start breathing on its own.
‘Quantitative easing’ primer
On Wednesday, Fed chair Jerome “Jay” Powell is expected to announce that the central bank will begin tapering QE.
More formally known as large-scale asset purchases, QE involves the Fed buying billions of dollars worth of bonds to keep bond markets liquid1 and interest rates relatively low. In other words, it’s an effort to make sure it’s easy for consumers and businesses to borrow money and do so cheaply.2
As the economy and the markets were falling apart in March 2020, the Fed launched QE. The plan initially included the purchases of Treasury bonds and mortgage-backed bonds “in the amounts needed.”3 This was among a barrage of policy actions4 that helped the economy find a bottom and inflect upwards.
In June 2020, the Fed tweaked QE to consist of $80 billion per month for Treasury purchases and $40 billion per month for mortgage-backed securities. This is where we’ve been ever since, and it’s what the Fed is expected to begin dialing back this month.
A lot of struggling businesses benefited from low financing rates. A lot of homebuyers benefited from low mortgage rates. Many homeowners also took advantage to refinance their mortgages at lower rates.
The economy’s ‘substantial further progress’
As part of its mandate, the Fed has long been tasked with using its capabilities toward promoting price stability and a maximum level of employment.
Last December, the Fed said it’d continue QE until the economy made “substantial further progress” toward those goals. Again, more vague language. But recently, the Fed has suggested that the economy has made this progress.
After trending mostly below 2% for over a decade, the Fed’s preferred measure of inflation went above 3% this past April and has been hovering at 3.6% since June.
Like many economists, the Fed has attributed much of the recent pickup inflation to non-permanent factors like the ongoing supply chain disruptions. Nevertheless, Fed chair Jerome Powell acknowledged that “the ‘substantial further progress’ test has been met for inflation.“
And while total employment is still about 5 million jobs below February 2020 pre-pandemic level, it’s up 17 million from its April 2020 pandemic low, and the economy continues to add hundreds of thousands of jobs each month. In other words, it’s getting hard to argue that employment hasn’t made substantial progress.
What happens next
This is not the end of support from the Fed. It’s not even the end of QE. It’s the tapering of QE, which means the Fed will still be buying bonds – but it’ll be buying fewer bonds. So, there’ll continue to be some form of Fed support for many more months.
As the Fed gradually slows its bond-buying – all other things being equal – we could see long-term interest rates like mortgage rates rise.
Broadly speaking, higher financing costs could cause the economy to cool further, which should help inflation gravitate back to that 2% target level.
And all that said…
Monetary policy is incredibly complicated and nuanced. Everything I’ve mentioned above comes with lots of “Yes, but…” questions. There’s also always the risk the Fed will make or has made a “policy error.”
For the purpose of this conversation, know this: The economy was in trouble. The Fed intervened and helped the economy turn around. For months, the economy has been recovering. And now the economy is in good enough shape that the Fed will soon begin dialing back its emergency monetary policy actions.
Everything else is details.
In case you missed it, here’s what I wrote last week:
As the stock market has surged to new record highs, it’s actually become cheaper in the process. (Link)
There hasn’t been this many ongoing residential construction projects in the U.S. in decades. Housing bubble or something else? (Link)
📈 Stocks set record highs! The S&P 500 gained 1.3% last week and 6.9% in October to close at an all-time high of 4,605 on Friday. 👀 We’re also entering a historical sweet spot for the markets: LPL Financial’s Ryan Detrick notes that since 1950, November on average has been the best month of the year for stocks. Jeff Hirsch, editor of the Stock Trader’s Almanac, notes that November to January has historically been the best 3-month stretch for stocks. 👯♀️ So we’re clear, past performance is no guarantee of future results. Then again, Mark Twain once said, “History doesn’t repeat itself, but it often rhymes.”
🤕 Amazon’s costly headache: People use Amazon because Amazon will deliver you anything cheaply and quickly. To continue delivering on that promise amid the supply chain nightmare, Amazon is spending a fortune to make sure they can deliver. In fact, while they expect to sell $130 billion to $140 billion worth of goods during the holiday quarter, management warns that all that business could yield an operating profit of $0. Literally $0.
📱 Apple’s supply problems: Even a company as well-resourced and well-connected as Apple isn’t impervious to supply chain problems, which CNBC reports cost the company $6 billion worth of sales during Q3.
☕️ Wage hikes: Starbucks plans to raise its minimum wage to $15 an hour by next year, up from $12. Costco says it’s raising its minimum wage to $17 an hour on Monday, up from $16. These types of headlines are not flukes. New data from the Bureau of Labor Statistics showed wage growth hit a record high in Q3 – led by gains for the lowest paid workers! 🍾🍾 If you wanna know why pay is going up these days, read about me and the 4.3 million quitters.
🍔 Inflation check: McDonald’s has been raising prices to offset higher commodity and labor costs. Management said menu prices are 6% higher now compared to a year ago, indicating that inflation is very real.
🤔 Deflation check: Sure, the prices of a lot of things are going up. But here’s a thought from Microsoft CEO Satya Nadella: “Digital technology is a deflationary force in an inflationary economy. Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity.”
I can attest: The $1,100 MacBook Air I bought recently is far better and literally cheaper than the $2,400 Dell Inspiron my parents bought for me for college in 2000.
🤷♀️ Inflation? NBD for Americans: According to the findings of a new Gallup Poll, Americans’ confidence in the economy has deteriorated. The most widely-cited issues were led by “Government/Poor leadership,” “COVID-19,” and “Immigration.” “High cost of living/Inflation“ was relatively low holding the seventh spot on the list.
Meanwhile, “a record-high 74% say now is a good time to find a quality job.“ This finding was echoed in a recent Conference Board survey, which showed that the percentage of consumers saying “jobs are plentiful” less those saying “jobs are hard to get” was the highest in 21 years.
⚡️ Electric vehicles everywhere: Hertz, the car rental company, announced it’s ordering 100,000 Teslas in its effort to build out an electric vehicle fleet. Meanwhile, GM CEO Mary Barra reiterated that she expects her company to grow its EV business from $10 billion in annual sales in 2023 to $90 billion by 2030.
🙈 Face-off: Facebook is changing its name to Meta, and it’s changing its ticker to $MVRS from $FB as of December 1. Also, the Washington Post reported that Facebook prioritizes content that makes you angry in your newsfeed.
Up the road
The big event in markets and the economy next week is going to be the Fed’s monetary policy announcement, which comes on Wednesday afternoon.
The October U.S. jobs report will be released on Friday. Economists estimate that employers added 425,000 jobs during the month, helping the unemployment rate fall to an estimated 4.7% from 4.8% in September.
There are also some big companies announcing their quarterly results next week.
In markets, liquidity can mean a lot of different things. One way to think of it is that if markets are liquid, there’s a healthy balance of buyers and sellers. When there are very few buyers, prices tend to fall. When there are very few sellers, prices tend to rise. By stepping in as an aggressive buyer in the bond markets, the Fed not only kept bond prices from tumbling but also probably kept bond prices relatively high. (In bond markets, falling prices mean interest rates are rising. And so when the Fed bought mortgage-backed bonds, it helped keep mortgage rates low.)
Typically when the economy sours, banks will limit lending and borrowing rates will rise. QE is intended to counteract that.
“In the amounts needed“ basically means they weren’t setting limits. Because things were totally unprecedented in the world in a bad way.
QE was just one of many monetary policy tools the Fed threw at the economy at the onset of the pandemic. Near-zero short-term interest rates was another. My old colleague at Yahoo Finance Brian Cheung has a great plain-English glossary.