The Federal Reserve cleverly announced QE4 (the fourth round of quantitative easing) yesterday without actually calling it that. Over a year ago, the Fed embarked on “Operation Twist,” in which it purchases $45 billion per month in long-term Treasury securities and simultaneously sells $45 billion in short-term securities. By buying long-term bonds, the Fed puts upward price pressure on the price of these bonds and pushes down long-term yields. Conversely, selling short-term bonds causes short-term yields to increase. Operation Twist was put into place to flatten the yield curve—push long-term rates down to incentivize Americans to take out mortgages, and keep short-term rates higher than they would be otherwise to help savers.
The game plan has changed and another round of quantitative easing is on tap, whether or not Bernanke publicly admits it. When Operation Twist ends on the 31st of this month, the Fed will continue buying long-term bonds but stop selling short-term bonds. Additionally, they will continue buying $40 billion in mortgage securities every month. This puts the Federal Reserve on pace to have a balance sheet of $4 trillion by the end of 2013 (compared to $1 trillion before the 2007-2008 financial crisis).
Another policy changed was announced yesterday—instead of a timeframe for keeping rates near zero, the Fed has set benchmarks for when it will raise short-term rates: (1) An unemployment rate at or below 6.5%, or (2) an inflation forecast of 2.5% or more. Targeting inflation is not new to the Fed; in fact, most countries’ central banks have inflation targets, but targeting inflation and unemployment levels is new to the US and unique in the world.
Breaking it down
It seems that Bernanke and other Fed board members are unhappy with the speed of our economic recovery over the last 4 years. Keeping rates (artificially) low is supposed to be a catalyst for economic growth, as it makes borrowing money cheap and encourages consumers to spend money. Certainly, coming out of the Great Recession we had to do something to encourage economic growth, so that QE1 and possibly QE2 were necessary. At this point in the recovery, however, it’s no longer clear that the advantages of further quantitative easing outweigh the potential negative effects down the road.
On the other hand, we do think that the Fed took a step in the right direction by setting benchmarks for raising rates. This approach gives investors the ability to predict when the Fed will start pushing short-term rates above zero, and they can thus plan accordingly rather than being blindsided by a surprise rate increase. The stock market despises uncertainty, as evidenced by its recent stagnation as we wait for Congress and the President to figure out the budget and tax code for next year. At least now the Fed is now helping to provide some clarity in monetary policy.