The Fed’s decision surprises the market
The Fed’s decision not to reduce its QE (quantitative easing) program in September no doubt caught many analysts, money managers, traders, and retail investors off-guard. Since May, Ben Bernanke and the Fed have commented on the likelihood of the start of tapering in the second half of this year. As a result, the market pulled back from time to time over the course of the summer.
What is quantitative easing?
The quantitative easing program, with its current incarnation often cited as “quantitative easing unlimited,” is essentially a bond shopping program totaling $85 billion a month. These bonds include government treasuries (an investment in the government’s debt) and MBS (mortgage-backed securities, a type of investment that generates income for investors based on the rent collected from rental houses).
The effect of QE on interest and the economy
The Fed’s monthly purchases increase the prices of these MBS and government treasuries, as demand inflates. When there’s more demand, the interest (or return) that investors can receive falls, which keeps the overall interest rate low. It’s like having more kids when you only have one apple pie to share, so each one gets a smaller piece.
A lower interest rate isn’t exactly great for the investors thinking of buying those bonds later—unless the Fed continues to buy them in large amounts in the future, which would further increase the price of current bonds. But lower inflation is theoretically great for the economy.
When the Fed buys these bonds, the banks’ reserves increase, which allows them to lend more to borrowers to invest or spend. With an increased reserve, the interest rate on borrowed money lowers because there’s more cash in the financial system. That’s why, when you store money in your bank account right now, you get almost zero return.
Whipping people to spend and invest
What the Fed is trying to do is encourage people to spend more or invest more—seeing that saving cash or buying bonds doesn’t generate good returns. As interest rates lower, they make borrowing more attractive, which should lead to an increase in demand for loans and debt to “spend” if everything goes as well as planned. One interpretation of economic activity is based on how fast and how much cash is circulating. The higher the circulation, the higher the economic activity.
Positive effect on retail sales and fast food companies
With higher economic activity, more people are employed, which is positive for retail sales and which bodes positively for consumer ETFs like the Dow Jones Consumer Services ETF (IYC) and Consumer Discretionary Select Sector SPDR ETF (XLY). It should also help bring down the unemployment rate of those below age 25—the largest group of consumers that make a bulk of sales for fast food restaurants like McDonald’s Corp. (MCD), Yum! Brands Inc. (YUM), and Burger King Worldwide Inc. (BKW).
© 2013 Market Realist, Inc.