For the third time in the past 5 years, the Federal Reserve officially ended an experiment with quantitative easing (QE), known this time around as QE3 (uncreatively, the prior two became known as QE1 and QE2). The end of quantitative easing presents the next obvious question: When will the Federal Reserve hike rates (ignoring for the moment, of course, whether the Fed might implement QE4 before any rate hike)?

The current “consensus” among economists and other Fed watchers is that rates may rise sometime in June 2015.  But, is it likely that the Fed will really be able to raise rates in 2015?

Political Nature of the Fed

One overlooked component among Fed observers is the political nature of the U.S. central bank.  Statutorily, the Fed’s sole responsibility as a political institution is to balance maximum employment with low inflation in the most prudent manner possible.  This vague dual mandate (at least in implementation) leaves lots of room for the Federal Open Market Committee (FOMC) to generally listen to whatever voices seem politically or economically reasonable.

A Little History on the Fed Funds Rate

Given the political nature of Federal Reserve policy, one might ask: What has the Federal Funds rate been by U.S. president? The following graphic is a look at this issue from the effective Federal Funds rate perspective (please note that the y-axis is scaled differently for every president).

Federal Funds by President (Different Scaled Axes)(1)

Starting from the top, President Eisenhower saw two tightening cycles during his presidency, although the effective Federal Funds rate never got much above 4%. Second from the top is President Kennedy.  The graph is shortened because of Kennedy’s assassination.  Overall, Kennedy’s entire presidency was generally one of tightening, with the Fed’s effective rate reaching around 3.5% at the end of Kennedy’s life. Third from the top is President Johnson.  Akin to President Eisenhower, President Johnson saw the Fed implement two tightening cycles during his tenture, with the Fed Funds rate reaching a little over 6% at the end of his Administration.

Following President Johnson is President Nixon.  President Nixon came into office with the Federal Reserve in the middle of a tightening cycle.  Shortly thereafter, the Fed began lowering the target Fed rate, bottoming at around 4%.  The Fed Funds rate didn’t stay at 4% very long, with the Fed quickly increasing its short-term borrowing rate up to a high of about 14% at the end of Nixon’s tenure. In contrast to President Nixon, President Ford came into office with the Fed in the middle of a loosening cycle.  Briefly, after about a year in office, the Fed raised its target rate.

Following President Ford was the Carter Administration.  Of all the presidential administrations that would complain about Fed policy, the Carter Administration likely has the most reason to gripe.  After the Fed let inflation get out of control, they hiked interest rates to as high at 20% before Cater lost his reelection bid to President Reagan.  Reagan came into office at about the time the Fed felt it was getting a handle on inflationary pressure.  Thus, the Fed target rate declined steadily to around 5% during Reagan’s second term.  About half way through Reagan’s second term, the Fed initiated a tightening cycle, bring the rate to around 8% at the end of Reagan’s Administration.

Following Reagan’s time in office, the first President Bush saw the Fed Funds rate only briefly rise during the initial few months of his presidency, after which the Fed began addressing the early 90s recession. Interestingly, President Clinton generally saw a stable Federal Funds rate, increasing at the beginning of his presidency, slightly declining towards the end, and then increasing again during the technology boom run-up. Following President Clinton, President Bush (II) saw two very textbook-like loosening cycles and one tightening cycle.

Lastly, President Obama came to office when the economy was just recovering from the housing market bubble.  If one looks closely, the Fed Funds target rate has not been changed during his tenure (the jumps in the graph are the daily cycles in the effective rate; observe the y-axis which shows the effective rate going from 0 to about 0.6%).


With the lack of any movement in the Federal Funds target rate during President Obama’s administration so far, one has to wonder if President Obama will be the first U.S. president to never see a Fed rate hike.  The answer is likely yes.

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The investment banking world seems to be quite concerned about the so-called “end of QE3.”

End of QE3 a Top Concern and Well-Grounded in Experience

Indeed, in discussions about global economic conditions, current top concerns seem to put the end of QE3 just as high in importance as slower, but still robust, growth out of China or a potential recession in Europe (some analysts perhaps even have the end of QE3 as higher than China or Europe concerns).

The investment bankers’ concerns about what the end of QE3 might mean for the market are well grounded in recent equity market performance. The figure below depicts the performance of the S&P 500 and the expansion of the Federal Reserve core balance sheet. Three points are important. The end of QE1. The end of QE2. And the end of QE3. If one follows these points upwards to the performance of the S&P 500 (top graph), it clearly shows a connection.

1 QE jsd.fw

History of Quantitative Easing

Now some background. QE1 ended in June 2010. In anticipation of the end of QE1, the market responded, with the S&P 500 declining around 15% from peak to trough (April to mid-August).

The response of the market and concerns about the strength of the economy led the Fed to announce $30 billion in Treasury securities, keeping the Fed’s balance sheet at $2.05 trillion (absent this move, the Fed’s balance sheet would have naturally declined as bonds are paid off).

In Bernanke and Fed officials’ views, the economy was still on shaky ground. Only five months after officially ending QE1, the Fed announced QE2, a $600 billion bond-buying program. QE2 didn’t last too long, ending in July 2011. Akin to the end of QE1, the market was displeased with the Fed’s actions, with the S&P 500 dropping about 15% from peak to trough.

About a year after the end of QE2, the Fed was concerned of continued slack in economic activity. The Fed’s response, unsurprisingly, was QE3. On September 13, 2012, on an 11-1 vote, the Fed announced QE3, initially set at $40 billion per month. The $40 billion per month wasn’t high enough in the Fed’s view, pushing the bond-buying program to $85 billion per month soon after the start of QE3.

About 9 months after the announcement of QE3, the Fed began tapering policy, initially dropping the bond purchase program from $85 billion to $65 billion.

Market Starts to Think About the End of QE3

With the Fed now close to ending QE3, it’s completely unsurprising to see the market start to react. Since September 18th, the S&P 500 is down about 4% as of writing. This decline leads one to wonder: which will come first – a Federal funds rate hike or QE4? With the history of quantitative easing as background, would you guess a rate hike or QE4 would come first?

Presuming QE3 ends in November/December, and the Fed’s current path of increasing the federal funds rate in June 2015, the Fed has to make it 7 to 8 months of no quantitative easing before it raises rates. Will the Fed make it to June 2015 without further balance sheet expansion?

If the previous four years is the guide, the answer is no. The market doesn’t want QE to end and the Fed is generally a market pleasing institution. Will it oblige to market opinion? Probably yes.

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Generally, investment bankers have been pleased with central bank policy over the past five years. So why are investment bankers happy with central banks?  There are two main reasons.

First, investment banks benefit from the increased risk taking, trading activity, and deal volume that lower interest rates encourage. Second, keeping interest rates low reduces any interest costs on investment banks’ balance sheets. With these two reasons in mind, it is completely unsurprising that investment bankers are nervous about impending rate hikes in the U.S.

Central Bankers’ Loosening Cycles

As of writing, observers of Federal Reserve policy place the end of the current loosening cycle (a time when the Fed is not increasing interest rates) somewhere around June 2015.  (The June 2015 is squishy; even voting members of the FOMC disagree strongly on when rate hikes will take place.) Presuming the Federal Reserve actually raises rates early next summer, it would mark the end of the current loosening cycle that began September 18, 2007.

A loosening cycle of eight years is quite long.  What makes the current Fed loosening cycle so interesting is that Yellen and company have not only kept rates low for so long, but that they have kept rates so low.  In addition to being the longest loosening cycle ever, the Fed has interest rates at the lowest levels in history.

Investment bankers, of course, cheer such policy on.  However, are investment bankers really happy with how much savings is missing in the world because of historically low central banks’ policy rates?

A Look at the Numbers

The first graphic shown contains a history of what central bankers across the globe have done with their main policy rate since 1990. Overall, rates have been on a long-term trend downward for some time. The chart also shows that central banks generally think alike, with very little competition for business.

1 Central Bank Policy Rates

Moving on to the topic of interest – savings. When investment bankers encourage the Federal Reserve and other central banks to keep interest rates low, they are adversely affecting some individuals. Chief among those adversely affected are savers, a large portion of whom are young workers and elderly or soon to be elderly Americans.

By how much have central bankers adversely affected savers? The following two graphics have the answer. (A note on the numbers: interest income statistics by country comprises a number of estimating procedures; the following numbers are best interpreted as rough estimates.)

The first graphic puts the missing interest income at about $1.6 trillion in 2014, or about 2% of global GDP. The second graphic looks at the missing interest income on a cumulative basis.  The cumulative missing interest income (savings) is around $7 trillion (2009 to 2014). The places where savers have been hurt the most are in Europe ($1.5 trillion), the U.S. ($1.4 trillion), and China ($800 billion).

2 Missing Interest Income

3 Cumulative Missing Interest Income

Is the Missing $7 Trillion Worth It?

How can investment and central bankers argue that the global economy is better off without the $7 trillion? The answer is that investment bankers and like-minded individuals think the global economy has been boosted by at least $7 trillion. Is there evidence that the global economy has been boosted by $7 trillion? The honest answer is – no.  There is literally no evidence.  In fact, if one simply takes correlation as evidence, the current economic situation is much worse than historical recoveries would have predicted.

Therefore, whether hurting savers has helped the global economy comes down to presumptions, not evidence.

The Question at Hand

Getting back to the question posed originally – are investment bankers happy with how much savings is missing in the world? The answer is probably yes.  Investment bankers, as a group, see the missing $7 trillion as more of a “thank goodness that cost is not there” situation. Whether they are right that hurting savers by $7 trillion is worth any potential benefit depends entirely on your assumption about the state of the global economy.  It has nothing to do with evidence.

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The Global Retail Sales Recovery

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Money Supply and Equity Market Performance Since 2007

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