QE3: The ship has sailed

Posted on Posted in Financial Blog

Yesterday, the US Federal Reserve announced what is commonly called “QE3,” which stands for “quantitative easing, round 3.” This is an unconventional form of monetary easing in which the Fed buys longer-term bonds on the open market, either Treasuries or US Agency securities. For this particular round, the Fed says that they will buy $40 billion each month of Agencies, specifically mortgage-backed securities. There is no dollar target or limit on QE3, which means they will continue to buy $40 billion of bonds each month until they are satisfied that the economy is on the right track.

What does this mean to the economy and to the financial markets? Well, if yesterday’s +1.6% rise in the S&P 500 is any indication, it’s good news for the latter. Overseas markets did even better, and many currencies, including the euro, rose against the dollar. Both oil and copper moved up as well. The reason QE3 is good for financial assets and commodities is that by putting more cash in banks’ hands, there are more dollars available with which to buy those assets. In addition, QE3 will tend to keep longer-term interest rates down, helping the mortgage market and making borrowing for corporations and individuals cheaper. It also keeps down borrowing costs for hedge funds, which are big buyers of “risk” assets such as stocks.

As for the US economy, QE3’s effects are less clear. The Fed’s main reason for initiating it was to help drive down the unemployment rate, based on an economic theory known as the “Phillips Curve.” The curve illustrates an inverse relationship between inflation and unemployment, suggesting that higher inflation can reduce the unemployment rate. Conversely, high unemployment leads to lower inflation. The Fed may thus be trying to increase the inflation rate in order to generate a pickup in hiring. They did this quite successfully in the years following WWII, but ran into trouble trying it again in the 1960s, when there was little slack in the economy. Some argue (I am one of them) that this was a major cause of accelerating inflation in the 1970s.

Runaway inflation is unlikely this time around because the US economy is still operating well below capacity. Once excess capacity and unemployed workers are soaked up, however, the Fed will need to back off quickly and “mop up” the excess liquidity (cash) in the system. Do this too early, and they could trigger another recession. Wait too long and they could create another 1970s-style wage-price spiral. Bernanke may be hoping he’s no longer Fed chief when these decisions have to be made.

Many argue that the US economy doesn’t “need” QE3, and that the risks outweigh the potential benefits. This may be true, but one must not underestimate the positive effects on business and consumer confidence of lower interest rates, brisker home sales and refinances, and higher stock prices. I know many of our clients are smiling already!

Lastly, although Fed policy has certainly been sufficiently loose for a while and probably doesn’t need to get any looser, there are two central banks that are still too tight in my opinion: the ECB and the Bank of China. One of the beneficial side effects of QE3 may be to spur these central banks to increase their money supplies in response, in order to keep their currencies from appreciating too much against the dollar and reducing the attractiveness of their exports. Should they loosen meaningfully, we should see a significant rebound in European and Chinese economies, which will in turn lead to an acceleration of global economic growth, including in the US. So in the end, the Fed’s actions may be targeted overseas as much as here at home.