What the End of QE Will Mean

Fed Building

Many commentators have suggested that the good performance of both stocks and bonds in recent years has been largely due to the unconventional ways the Federal Reserve has tried to boost the economy. Chief among these has been its “quantitative easing” programs (or “QE”) that essentially use newly created money to buy bonds. With the Fed recently announcing the end of its third QE program, it’s tempting to think that markets may now be primed for a fall. The relationship between QE and investment performance, however, isn’t quite so simple.

It may seem obvious that stock prices rose because money from QE flowed through the financial system and into the stock market. But stocks also could have risen for other reasons, such as an improving economic outlook. The purpose of QE (and other Fed policies in recent years) was to boost the economy, and the economic growth rate has indeed increased: 4 of the last 5 quarters have been among the best since the financial crisis in terms of the GDP growth rate. It’s difficult to disentangle how much of the stock market performance was due to the side effects of QE rather than the improving state of the economy.

Similarly, it may seem obvious that bond yields have stayed low because the Fed has been buying bonds in its QE programs. But part of the reason the Fed initiated its QE programs was that economic growth and inflation were so low, which would also explain low bond yields. It’s even possible that QE led to higher bond yields as a result of the improved economic outlook, so the overall effect of QE on bonds is ambiguous.

Historical evidence leads to similar conclusions. The bull market survived the Fed ending its previous QE programs, and stocks have continued to rise since the Fed began winding down its current program almost a year ago.

Instead of focusing on the specific effects of QE, it may be more constructive to focus on the broader contours of the Fed’s policies. If it turns out that the Fed has pulled back its support of the economy too quickly, stocks are indeed likely to suffer. But if the Fed has correctly judged that the economy can continue to chug along, the bull market is may continue for a while longer.