The Federal Reserve's quantitative easing (QE) program inevitably affects the stock market, although it is difficult to know exactly how and to what extent. The evidence suggests that there is a positive correlation between a QE policy and a rising stock market. In fact, some of the largest stock market gains in U.S. history have occurred while a QE policy was underway.

Key Takeaways

  • A QE policy is intended to increase economic activity by injecting more cash into the system.
  • The Federal Reserve purchases bonds so that banks will use the cash proceeds to make new loans to businesses and consumers.
  • Investors anticipate stronger business revenues and invest in companies that are expected to profit.

After all, the purpose of a QE policy is to support or even jumpstart a nation's economic activity. In practice, QE policy entails buying massive amounts of government bonds or other investments from banks in order to inject more cash into the system. That cash is then loaned by the banks to businesses, which spend it to expand their operations and increase their sales. Stock investors anticipate the increased company revenue and buy the stocks.

That's the big picture, but there are other, more subtle, effects of a QE policy on stock prices.

Investor Expectations

The stock market responds to virtually any news of Federal Reserve activity. It tends to rise when the Fed announces an expansionary policy and fall when it announces a contractionary policy.

Perhaps market participants like the prospects of rising asset prices during the early stages of inflation, but it is more likely that confidence rises on the expectation that the economy will be healthier after expansionary policy.

The QE Effect

Quantitative easing pushes interest rates down. This lowers the returns investors and savers can get on the safest investments such as money market accounts, certificates of deposit (CDs), Treasuries, and corporate bonds.

Investors are forced into relatively riskier investments to find stronger returns. Many of these investors weight their portfolios towards stocks, pushing up stock market prices.

Falling interest rates also influence the decisions made by public companies. Lower rates mean lower borrowing costs. Companies have an incentive to expand their businesses and often borrow money to do so.

Fundamental analysis holds that business expansion is a sign of a healthy operation and a positive outlook on future demand. That inspires investors to buy stock, which causes stock prices to rise.

How the Fed Manipulates the Economy

Some economists and market analysts contend that QE artificially inflates asset prices. Under normal conditions, market prices are determined by investor preferences, or demand, and the relative health of the business environment, or supply.

QE4

QE4 began in September 2019 and represents the latest round of quantitative easing launched by the Federal Reserve since the 2008 financial crisis.

When the Federal Reserve begins entering the market to purchase financial assets, it manipulates price signals in three significant ways: It lowers interest rates, creates a higher demand for assets, and reduces the purchasing power of money units.

Under these conditions, a stock's price may no longer be an accurate reflection of a company's valuation and investor demand. Manipulated prices force market participants to adjust their strategies to chase stocks that will grow whether or not the underlying companies are actually becoming more valuable by any measure of success.

In the U.S., there have been four periods of QE policy since the 2008-2009 financial crisis began. The most recent, QE4, began in September 2019.

When the Flow Stops

At some point, a QE policy ends. It is uncertain what happens to the stock market for good or ill when the flow of easy money from central bank policy stops.

The Federal Reserve added more than $4 trillion to its balance sheet in the half-decade between 2009 and 2014. Those are huge liabilities for the Fed, and 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.

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 in the late 1990s helped to inflate the early 21st-century housing bubble in exactly this manner.

It is theoretically possible stock market prices could crash like those housing prices in 2008-09 if the same phenomenon results from QE.