Fed’s QE policy: To Infinity And Beyond! by Colin Moore, ColumbiaManagement
- Financial markets are now questioning the time limit on an infinite QE policy and what lies beyond its expiration.
- While volatility and corrections are unpleasant, they can motivate investors to focus on fundamental issues such as capital investment and labor productivity.
- The transition from our focus on extraordinary monetary policy may be painful, but it will be worth it.
“To infinity and beyond!” is the catchphrase of Buzz Lightyear, the popular character from Disney’s Toy Story franchise. The phrase is both whimsical and paradoxical. The character of Buzz was inspired by Apollo 11 astronaut Buzz Aldrin; but the phrase may be a tribute to Stanley Kubrick’s 2001: A Space Odyssey, in which the concept of “Jupiter and beyond the infinite” was introduced.
The world’s financial markets have been bolstered by a series of extraordinary measures taken by central banks generally but led by the U.S. Federal Reserve (theFed). The Fed’s actions, known as quantitative easing (QE), have been grouped into phases (QE1, QE2) culminating in QE Infinity. The name “QE Infinity” implied that this extraordinary policy would last a very long time. However, financial markets are now dealing with their own paradox: What is the time limit on an infinite policy and what lies beyond its expiration? Transition points are often the source of market volatility as the certainty of the previous focus is replaced by the uncertainty of the new focus. In addition to increased volatility, we may also experience a correction, loosely defined as a drop in major indices of at least 10%. While volatility and corrections are unpleasant, they can motivate investors to focus less on QE (an extraordinary but cyclical policy response), more on longer term fundamental issues such as capital investment and labor productivity leading to higher sustainable economic growth rates.
Over the past several years, I wrote about the concept of a square root economy, during which we faced multiple years of structurally lower economic growth following the great recession. Six years ago many commentators assumed the recession would be followed by strong growth. Recessions are often caused by the need to correct cyclical excesses. So assuming the underlying trends are strong, it is not unreasonable to expect a strong bounce back. However, I believed then and continue to believe that the great recession was caused by significant structural issues of leverage, lack of long-term investment in infrastructure and education and an aging workforce. The headline-grabbing sub-prime mortgage issues and the behavior of banks, etc. were very important but they were and are symptoms of the structural issues.
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Another concept I have embraced in recent years is the valuation of equity markets based on a very simple equation:
The impact of central bank policy was to reduce investor expectations of risk. If the economy began to sink again, the central banks through their infinite ability to create liquidity would refloat the ship. Therefore in our simple equation, a lower expectation of risk causes the valuation to rise. I strongly believe the impact of this is relatively short term. The reduction in risk expectations is a necessary condition to create growth, but it is not sufficient. We need politicians, corporations, investors and the general public to change policies, business plans, investment horizons and saving/spending habits to improve structural growth.
Perhaps we should not just focus on the whimsical or paradoxical nature of Buzz Lightyear’s catchphrase. Perhaps its greatest impact is its aspirational nature. If the extraordinary concept of reaching infinity is not enough, then I suggest we need to think beyond QE Infinity and focus on long-term sustainable growth. The transition from our focus on extraordinary monetary policy may be painful, but it will be worth it.