On June 19th, Federal Reserve Chairman Ben Bernanke announced that the Fed will likely slow its $85 billion per month bond-buying program by the end of the year, and could conclude the practice entirely in 2014. Over the course of the two days that followed this announcement, the stock market plunged and 30-year fixed-rate mortgages jumped over half a percent.
Based on those immediate reactions, some may perceive that Chairman Bernanke’s announcement portends adversity for the U.S. economic recovery. But with unemployment rates dropping, retail sales increasing, consumer confidence rebounding, and the housing market rallying, the announcement should rather be regarded as a positive indication that America is finally in the midst of a sustainable—albeit slow—economic recovery.
Just a few years ago, the collapse of the housing market and banking system left a crater in our financial system: major stock indices ultimately declined over 40 percent. In what felt like the blink of an eye, trillions of dollars of market value essentially vanished, and virtually all lending and borrowing ceased as a result. The United States encountered its deepest and longest period of financial distress since the Great Depression.
Responding with an aggressive strategy, the Federal Reserve began purchasing $85 billion worth of bonds each month with the explicit intention of lowering interest rates on loans for companies and for individuals. With this goal in mind, the strategy was an unmitigated success. Because a one percent decrease in interest rates generally lowers monthly mortgage payments by as much as ten percent, buyer demand was virtually compelled to return.
The Fed’s monthly bond purchases on the open market also flushed with cash those investors who were previously holding bonds. For returns greater than bonds now provided, these investors sought opportunity in stock markets that had been driven to a nadir by macroeconomic concerns, and ultimately catapulted major stock indices upward.
As low interest rates increased demand in the housing market and rebounding stock markets prompted consumer spending, the U.S. economy showed considerable progress. While the Federal Reserve played a vital role in reigniting the economy, it did so with $3 trillion of manufactured money. Most have understood that this strategy was unsustainable long term, as it would propel inflation once the economy truly recovered.
After pouring over mountains of data indicating that the economic recovery was increasing in strength, the Federal Reserve announced that it might finally be able to taper its quantitative easing efforts. Having grown accustomed to the ’umbilical cord‘ the Federal Reserve was providing to the economic recovery, sensitive markets—especially equity markets—reacted negatively initially.
At this point, it is important for consumers not to overact to such short-term volatility. With inflation still well below historical levels, the Federal Reserve would only end quantitative easing if it were confident that the U.S. economy was sufficiently buttressed by increasing underlying strength.
Despite any negativity from short-term market prognosticators, the tacit confidence shown by the Federal Reserve is a good sign for the long-term health of our economy. The fact that the Federal Reserve finally feels ready to transition the U.S. economy to greater independence should be regarded as a signal that the economy is ready to stand sustainably on its own.