Fed & QE3…


Written by: Jon McGraw

Today, the Fed Open Market Committee concluded their two-day meeting with some big news—QE 3. Specifically, the FOMC will buy $40 billion of mortgages per month in an effort to spur the recovery in real estate and keep rates for government agency debt low (until the labor market improves ‘substantially’). Additionally, they lengthened and toughened their ‘zero-rate policy’ language from late-2014 to mid-2015. In addition, they stand ready to do more as needed.

This outcome, as has been the case of the last few meetings, was largely expected. However, up until a few days/weeks ago, it wasn’t as clear as to whether such as drastic step would need to be taken. Last week’s poor jobs report and ongoing spottiness in economic data (particularly in manufacturing) appeared to prompt this decision.

What does this version of QE represent? Likely, a loosely-defined and open-ended bond purchase program. The program is simple in theory, considering that, with short-term rates near zero, there isn’t a lot of wiggle room left on the short end of the yield curve to ease further. So, by buying bonds, the Fed can push down yields (this is done through the fairly straightforward formulas of: Fed buying of bonds = higher demand = higher prices = lower yields). This keeps overall interest rates lower than they would otherwise be and continues to stimulate business and consumer spending, as low yields on debt are also connected to low borrowing rates—including those on mortgages, autos and capital equipment.

This is by no means a panacea. Some economists argue that another round of QE isn’t likely to be extremely effective, and each round has a lesser chance of being effective than the last. Ben Bernanke spent a fair amount of time at the Jackson Hole conference defending the Fed’s monetary policies during the financial crisis, and provided his own evidence that QE did, in fact, work, by raising output by 3% and creating some 2,000,000 jobs. If the economy remains in a slow growth pattern, QE is likely better than nothing; although other, more qualitative concerns, such as the upcoming presidential election and year-end ‘fiscal cliff’ continue to weigh on investors as well.

That said, investment markets have tended to react quite favorably to easing announcements historically. Equities may be the most direct beneficiary, but corporate ‘spread’ debt and industrially-oriented commodities may also benefit. (Markets today already like it.)

Another piece of this puzzle that complicates matters somewhat is the Fed’s dual mandate of ‘stable prices/moderate long-term interest rates’ and ‘maximum employment.’ The employment portion of this may be the trickiest part, as political and non-monetary concerns come into play and a period of longer-term structural employment (Bernanke’s worst fear) could potentially come into conflict with the other mandate. Also, in terms of questions, what is left in their arsenal if this isn’t as effective as hoped?