The bull market weíve enjoyed for the past four years has been supported by the Federal Reserveís asset-purchasing program, also known as quantitative easing. The Fed has pumped trillions of dollars into our economy since it began buying Treasury notes in November 2008. At the moment, the purchases consist of $85 billion a month in bonds, and Fed chair Ben Bernanke said in mid-September that the purchases would continue for the time being.
Since the first round of quantitative easing started, the Standard & Poorís 500 Index has more than doubled. Thatís not all the result of the asset purchases, of course Ė the economy has officially been in recovery since June 2009 Ė but itís undoubtedly had an impact.
There have been three phases of this quantitative easing program, QE, QE2 and QE3, and most financial observers expect that there wonít be a QE4. So the scenario weíre facing is that at some point fairly soon, the Fed will begin gradually tapering off the purchases off those bonds, in whatís commonly known as the taper.
Ben Bernanke has indicated on several occasions that the process wonít begin until the overall health of the economy is strong enough to warrant it. The Fedís eye, remember, is on its dual mandate of employment and inflation, so any effect its decisions have on the markets are incidental.
Not surprisingly, then, the timing of the taper depends strongly on the state of the unemployment and inflation figures. Bernanke has signaled that the Fed wonít consider the economy strong enough to end the bond purchases until the unemployment rate reaches 7.0 percent, while the inflation rate is still under 2.0 percent.
The unemployment rate, as of the end of August, was at 7.3 percent and dropping at about one tenth of a percentage point per month. At that rate, weíll reach the Fedís target toward the end of this year. As for the other side of the equation, the inflation rate is 1.7 percent, as of the last official reading of the core Consumer Price Index. So itís very likely that the taper could come before 2013 is over.
What happens then? We got a signal back in June, when Bernanke first announced after a Fed meeting that the taper was probably going to happen sooner rather than later. The day after the announcement, the S&P 500 Index had its worst trading day since November of 2011, losing 2.3 percent of its value.
Clearly, investors didnít like the idea of the asset-purchasing program ending. On the other hand, the marketís drop was short-lived. Within two weeks, the S&P had rebounded to where it had been prior to Bernankeís announcement, and the index continued to rise throughout much of the summer.
It was almost as if the markets, after a momentís panic, remembered that they knew all along that the Fedís quantitative easing was going to end sometime. After the initial surprise, stock prices kept marching upward as if nothing had happened.
When Bernanke finally announces the definitive end of the asset purchases, there will have been a lot more prior warning than there was before that June announcement. Investors know the taper is coming, and they even have a good sense for when it will happen. Itís likely that the market has already priced in whatever effect the end of QE will have.
The larger question is what might happen to stock prices over the long term without the extra boost from the Fed. No one can predict the future, but there are reasons to believe, with all the care the Fed has given to a soft landing, that the taper shouldnít be tremendously disruptive to investors.