The Federal Reserve

Quantitative Easing and Interest Rates

The Federal Reserve

Question: Should I be concerned about the recent news about the Fed reducing bond buys soon and its effects on my portfolio?

Answer: Lately, it seems that a day does not go by without a story like this one which talks about the eventual tapering of the Federal Reserve’s Quantitative Easing (QE) program and its impact on the financial markets. Recall that QE involves the Fed purchasing $85 billion per month of long-term government obligations (including government guaranteed mortgage-backed securities) using its ability to create account balances via computer entry. Some pundits (e.g., Peter Schiff) have postulated that asset prices (particularly equities and long-term bonds) have been artificially inflated by QE, and once it winds down, the market is in for a rude awakening. The metaphor most commonly invoked is that of drug addict who will either eventually die (from the onset of hyperinflation) or have to suffer the agony of withdrawal (a severe bear market).

Eugene Fama, a 2013 Nobel Laureate in Economics and the father of modern finance, recently published a working paper1 that questions whether the Federal Reserve controls interest rates, as is so commonly thought. Fama ran multiple regressions of interest rate data from 9/27/1982 to 6/29/2012 (a period of 29 years and 9 months). He found that when the Fed changes its Target Federal Funds rate (for which there are 151 data points), it tends to do so in the direction of existing market-based interest rates, especially short-term rates. While it is possible that market rates move to where market participants think the Fed will go, it is equally possible that the Fed is a passive player that follows the market. Furthermore, it does not have to be entirely one or the other. While Fama’s paper left open the question of whether the Fed controls interest rates, Fama himself has a very strong opinion that he recently shared with InvestmentNews magazine.

“I don’t think the Federal Reserve has any role in how high rates are right now. I don’t understand why everyone is paying attention to this tapering. The Fed is using one kind of bond to buy another kind of bond. What’s the big deal, and why is anyone taking the Fed seriously?”

Fama’s essential point is that if the Fed’s actions truly determined interest rates (i.e., bond prices), then not only should long-term interest rates have decreased, but short-term rates should have increased, yet they did not. IFA’s position is that most investors will not profit themselves by joining the legions of Fed watchers and others who make a fetish of parsing every word that comes out of the Fed’s meeting minutes. All of it is reflected in today’s prices. Investors who base their asset allocations on speculation about what the Fed will or will not do are setting themselves up for disappointment. 

Here is an interview of Nobel Laureate Eugene Fama on this subject on CNBC:

1Fama, Eugene F., Does the Fed Control Interest Rates? (June 29, 2013). The Review of Asset Pricing Studies, Forthcoming; Chicago Booth Research Paper No. 12-23; Fama-Miller Working Paper. Available at SSRN: http://ssrn.com/abstract=2124039.