Since the Federal Reserve first announced that it was going to experiment with monetary policy in December 2008, the brain trust at the Fed has "stimulated" like never before, pushing interest rates down to what would have been unthinkable lows just a decade ago for an extended period of time. Obviously, their interference in what passes for a free market economy has some key negative impacts that I will outline here.
1.) The prolonged period of near-zero interest rates has pushed investors into riskier investments in a search for yield. This can quite easily be seen in ICI's monthly net new cash flow into equity mutual funds as shown on this graph:
Given that the market saw a major correction as the Great Recession took hold, you would think that investors that can ill-afford capital losses would have learned a lesson but apparently such is not the case. If/when the market does retrace its QE-fed gains, it could look like 2007 - 2008 all over again. There goes that elusive "wealth effect"!
2.) All sectors of the economy have been living in a debt fantasy world as shown on this graph:
With ultra-low interest rates on outstanding debt, as a whole, all sectors of the economy have been accruing unsustainable levels of debt. Total debt liabilities have grown from $51.971 trillion at the beginning of 2008 to $59.398 trillion in the first quarter of 2014, an increase of $7.427 trillion.
3.) The Federal Reserve now holds a significant and unprecedented portion of the Federal debt as shown on this graph:
Here is a chart showing the current composition of the Fed's balance sheet:
At the end of April 2014, the Fed held $2.35 trillion in U.S. Treasuries, up $415 million from the year before. At the end of the first quarter of 2014, there were $12.591 trillion of outstanding Treasuries. This means that the Federal Reserve holds 18.7 percent of all outstanding federal government market debt.
Some economists feel that the Fed will have no problem managing an orderly reduction of its balance sheet if it holds all of the debt to maturity. The fly in the ointment is that when interest rates begin to rise, the value of the Treasuries held by the Fed will drop. This would likely eliminate the ability of the Federal Reserve to remit its annual profits to the Treasury. This is not an inconsequential amount as shown on this graph:
In 2013 alone, the Fed made $90.4 billion in interest income and remitted $77.7 billion to the Treasury Department. To put this number into perspective, this is roughly the amount that was budgeted for Transportation in fiscal 2014. While not terribly significant, if the $78 billion was not remitted to the federal government, Washington would have to add the amount to its annual deficit.
As well, some economists feel that the Fed's dramatic expansion of its balance sheet through the purchasing of Treasuries has allowed the government to finance its deficit by adding to the money supply since the money used to purchase the Treasuries is created out of thin air. With interest rates so low, there is no motive to reduce deficit spending.
3.) Speculation surrounding QE has had an upward impact on commodity prices. This can be seen on this graph of the producer price index for all commodities which is now above pre-Great Recession levels:
As a result of QE, the financial industry was forced to find a new asset class that rewarded investors with a better than zero percent yield. This asset class was commodities. Through the promotion of alternative investments like commodities, hedge funds were able to earn fees based on their services as they invested clients funds in various commodities at the same time as commodity prices rose. A study by Gueorgul Kolev concluded that a permanent one percent increase in the United States monetary base resulted in a one percent increase in the price of commodities. As we all know, commodity price inflation can be counterproductive to long-term economic growth.
4.) As investors perceive the impact of the Federal Reserve withdrawal from the bond market, they will begin to sell bonds, pushing the price of bonds down and yields up. In this scenario, there is a risk that interest rates will rise more quickly than inflation, making it increasingly painful for both the private sector and the government to refinance existing debt or finance new debt.
No one, including the learned minds at the Federal Reserve, know when or if it is safe to remove the economic "training wheels" of unconventional monetary policy. At some point, the risks involved in either continuing or discontinuing monetary support will have to be faced. Most unfortunately, all the Federal Reserve has done since December 2008 is to buy more time rather than fixing the underlying economic problems that caused the near meltdown in the world's economy.