Federal Reserve launches third round of quantitative easing

Today at the regularly scheduled meeting of the Federal Reserve’s Federal Open Market Committee (the FOMC) voted to launch a new program of bond purchases (quantitative easing / QE3) and to extend their forward guidance about the fed funds rate. The Fed will purchase additional agency mortgage‐backed securities, at a pace of $40 billion per month, beginning tomorrow. There is no time limit set for these additional purchases.

U.S. stocks rose today over 200 points, sending the Standard & Poor’s 500 Index above its highest close since 2007, as the Federal Reserve said it will buy mortgage-backed securities to bolster the economy. Investors confidence that quantitative easing is working is best shown by the first attached chart. The second chart shows the impact past rounds of quantitative easing have had on interest rates.

What is quantitative easing? Short answer: It’s an unconventional monetary tool used by central banks to stimulate the economy.

Normally, when there’s a recession or the economy is limping along, the Federal Reserve will reduce short-term interest rates in order to spur more lending and spending. But right now, the Fed has cut interest rates as far as they can go and the economy is still struggling. This is known as the “zero bound.” The Fed can’t go any lower.

So, instead, the central bank can try quantitative easing. Since the Federal Reserve can just create dollars out of thin air, it can buy up assets like long-term Treasuries or mortgage-backed securities from commercial banks and other institutions. This pumps money into the U.S. economy and reduces long-term interest rates further. In theory, when long-term interest rates go down, investors have more incentive to spend their money now.

The Fed may continue these purchases until the outlook for the labor market improves substantially, meaning that there is now at least a broad (as opposed to specific) unemployment rate target for QE3. The current program of extending the average maturities of Fed holdings (Operation Twist) will continue through the end of this year. These actions are designed to put downward pressure on longer‐term interest rates, support mortgage markets, and make broader financial conditions more accommodative. The FOMC also voted to extend their forward guidance on the near‐zero fed funds rate, saying that exceptionally low levels of the fed funds rate are likely warranted through at least mid‐2015. The vote on the FOMC action was not unanimous. Voting against today’s policy action was Jeffrey Lacker of the Richmond Fed.

It is important to note that today’s MBS‐focused launch of QE3 has no specific end date. It is implied, but not specified nor guaranteed in the Fed’s statement, that the program will run at least through the end of this year, and possibly longer. The trigger to end the program will be substantial improvement in the labor market outlook. If the unemployment rate does not decline substantially by the end of this year, quantitative easing will likely extend into 2013. That the Fed’s so‐called reaction function is still undefined gives the Fed plenty of wiggle room to adjust policy down the road.

For more discussion on quanitative easing and federal monetary policy, please see this past issue of The Independence Voice

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