How does quantitative easing in the U.S. affect the stock market?

The Federal Reserve's LSAP plan, or large scale asset purchases plan, also known as quantitative easing or QE, affects the stock market, but it is difficult to know exactly how or to what extent. Empirical evidence suggests there is a positive correlation between QE and a rising stock market; some of the largest stock market gains in U.S. history occurred after the launch of LSAP. There are several possible explanations.

The stock market typically responds to news of Fed activity, tending to rise when the Fed announces expansionary policy and fall when it announces contractionary policy. Perhaps market participants like the thought of rising asset prices during the early stages of inflation, but it is more likely that confidence rises on the expectation the economy will be healthier after expansionary policy.

Quantitative easing also pushes down interest rates. This damages the returns for traditionally safe investments such as financial vehicles including money market accounts, certificates of deposit (CDs), Treasurys and highly rated bonds. Investors are forced into relatively riskier investments to find a return. Many of these investors weight their portfolios towards equities, pushing up stock market prices.

Falling interest rates also affect the decision-making of publicly listed companies. Lower rates mean lower borrowing costs. Companies have greater incentive to expand operations and become more leveraged. Fundamental analysis generally holds that business expansion is a sign of healthy operations and a positive outlook on future demand, which could cause stock prices to rise.

Some economists and market analysts contend that QE has led to artificially inflated asset prices. Normal market prices are determined by investor preferences, or demand; the relative health of the business environment, or supply; and other macroeconomic factors. When the Federal Reserve begins entering the market to purchase financial assets, it manipulates price signals in three significant ways: lower interest rates, higher demand for assets and reduced purchasing power of money units. Instead of stock prices acting as an accurate reflection of company valuation and investor demand, manipulated prices force market participants to adjust their strategies to chase stocks that grow without their underlying companies actually being more valuable.

It is unclear what happens to the stock market when there are no more low interest rates and easy money from central bank policy. The Federal Reserve added more than $4 trillion to its balance sheet in the half decade between 2009 and 2014. Not only are those huge liabilities for the Fed, they represent an important value for debt issuers everywhere. If the Fed lets the bonds mature and does not replace them, it is equally unclear what impact this could have on the bond market.

Interest rates play an important coordination role between savers, investors, lenders and companies that are expanding operations. Companies that stretch their capital into future operations may discover there is not sufficient demand to buy their goods. Some believe the low-interest rate policy of the Federal Reserve after the dotcom crash helped to inflate the housing bubble in exactly this manner. It is theoretically possible stock market prices could crash like those housing prices if the same phenomenon results from QE.