The Fed has just announced a new round of quantitative easing (QE3). Specifically, the Fed announced that it will start buying $40 billion worth of mortgage-backed securities per month (conditional on the performance of the labor market) and continue Operation Twist for the remainder of the year (sell short-term securities, buy long-term securities, $45b/month). Also, it indicated that it anticipates maintaining low interest rates through mid-2015. The goal is to reduce long-term interest rates, particularly mortgage rates, with the hope of increasing borrowing and spending in general and providing support to the housing market in particular.
How did financial markets react? I'm writing this at 12:45pm (15 minutes after the announcement). The initial reaction is a 0.5% increase in stock prices as well as some increase in gold & silver. However, oil and gas prices have not risen. What about long-term interest rates? Yields on ten-year Treasury bonds have risen significantly, from 1.72% prior to the announcement to 1.82% as of 12:50pm. Why would the yield on Treasuries increase? Some possible reasons include the fact that the Fed is going to purchases mortgage-backed securities instead of Treasuries and concerns about higher inflation.
Was it the right move? Argument in favor of it includes the weakness of the economic recovery (economic growth below 2% in the first half of 2012 & unemployment above 8% accompanied by subpar job growth). Also, inflation is running below 2% (the Fed's target). The hope is that lower long-term interest rates will spur growth providing some support to the recovery. That said, Ben Bernanke and other members of the Fed know and hae stated that there are limits to any benefits.
Arguments against include that this will probably have a very limited effect on economic growth. Interest rates are already near historic lows. Also, though overall inflation is below 2%, core inflation is close to 2%. Energy prices are already rebounding from recent declines, so overall inflation will rise in the coming months (beginning with tomorrow's inflation report). Also, as mentioned in a previous post, expected inflation as measured in the market for TIPS (treasury-inflation-protected securities) is not that low (break-even inflation over the next five years is about 2.1% and rising somewhat in recent weeks compared to significant declines prior to QE1 and QE2). Also, this will complicate the Fed's exit strategy.
What's the take away? Though the Fed has discussed the limits to another round of QE3, it chose to implement a new round of quantitative easing. It did make it contingent on the performance of the economy, so if the economy strengthens, it could choose to stop QE3 after a few months. More likely, it will continue well into 2013. Also, it can't be accused of trying to finance the budget deficit since it chose to purchases mortgage-backed securities instead of government bonds. What's my initial take? I would have voted no. I don't anticipate significant benefits and I think it introduces more distortions to financial markets that may be hard to unwind. Do I think it will lead to rapid inflation? Not anytime soon. I wouldn't be surprised if there are more posts on this topics in the coming days.