The Federal Reserve launches QE3: The power of positive thinking
Sep 13th 2012, 21:11 by G.I. | WASHINGTON
[Greg Ip] Earlier this year, the Federal Reserve reached a crossroads. It had lowered short-term interest rates to zero and promised to keep them there until 2013, and then 2014. It had undertaken multiple rounds of bond purchases to lower long-term interest rates. Yet the recovery was actually losing steam; unemployment had stopped falling. Was there anything left to try?
The answer, it turns out, is yes. The Fed made one of its most consequential announcements yet today. The detailed actions were, in themselves, similar to previous steps: it will buy $40 billion of mortgage backed securities per month, and extend the period of short-term rates near zero until at least mid-2015. But the game changer was what it said: it will keep buying bonds until, and beyond, when the recovery is firmly established. Specifically, the Federal Open Market Committee said in its statement:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability… [A] highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
There are two key innovations here, both aimed at altering expectations. First is the commitment to open-ended bond purchases. Last week, the European Central Bank put its unlimited capacity to print money to bear on the euro crisis by promising to buying peripheral country bonds with no “ex ante quantitative limit”. The Fed has done the same thing, though in the cause of boosting output rather than saving the euro. Do not underestimate the psychological impact on investors of “unlimited.”
The second innovation is that by setting a concrete benchmark for what it wants monetary policy to achieve, the Fed hopes to do more than what that policy alone has done. Its past rate commitments and bond purchases (twice financed with newly created money, called quantitative easing, and once by selling short-term bonds, dubbed Operation Twist) have certainly driven interest rates down and buoyed the stock market. But the economic results have been disappointing. A growing clamor of voices, from Paul Krugman and Christina Romer on the pages of the New York Times to Mr Bernanke’s friend and former co-author Michael Woodford at Columbia University have argued the Fed hadn’t done enough to harness the public’s expectations to the cause of recovery. Their preference was a radical shift in the Fed’s policy framework, to targeting a higher inflation rate or a higher path for nominal gross domestic product.
Such a shift was always a stretch for an inherently conservative institution such as the Fed. So Fed insiders, notably Charles Evans of the Chicago Fed and Janet Yellen, the vice-chairman, put forth close substitutes: commit to easy policy until the economy was much closer to full employment. Importantly, this would allow inflation to wander temporarily above its 2% target without requiring a departure from that target. Today’s statement is Evans-lite: it does not state a numerical target for unemployment or a tolerance level for higher inflation, but it comes close. Explaining the purpose to reporters, Mr Bernanke said,
The idea here is to make it more explicit and transparent to the public that … the Fed will do what’s needed to provide support. We hope that will provide a bit more assurance, maybe a bit more confidence the Fed will be there to do what it can. By assuring the public we will be prepared to take action if the economy falters, that will increase confidence, make people more willing to invest, hire and spend… If inflation goes above target, we take a balanced approach: bring inflation back to target over time but in a way that takes into account deviations of both [unemployment and inflation] from our target.
The decision to launch this third round of quantitative easing, or QE3, was a long time coming. As far back as June it had become apparent the economy was faltering. FOMC members have lowered their expectation of growth this year from between 2.4% and 2.9% in April to between 1.7% and 2% in this month’s projections. But within the Fed, many officials were losing faith in their ability to do anything about this. Mr Bernanke needed to persuade them, and himself, that more QE could help the economy and that any unwelcome side effects such as a more complicated exit strategy, or distortions to market functioning were manageable. That required extensive staff research and time. It also required data that showed the economy wasn’t getting better on its own. By this week, all those things were in place.
The length of the Fed’s deliberations frustrated outsiders who wanted easier monetary policy much sooner. Mr Bernanke reckons he sacrificed immediacy for durability. Eleven of the 12 voting FOMC members supported the action (Jeffrey Lacker of the Richmond Fed dissented, as he has all year). Fed chairmen have always preferred consensus, but it’s especially important in the current hyper-politicized atmosphere. Republicans have regularly launched broadsides against QE; Mitt Romney has said he will not reappoint Mr Bernanke after his term ends in 2014, and Barack Obama may not be able to get him confirmed even if he wanted to keep him. Investors may have wondered whether to trust a policy whose architect may not be around to see it through; such doubts would have undermined the Fed’s desired effect on expectations.
Mr Bernanke, without explicitly mentioning politics or his future, noted:
We were able to come to a pretty good consensus on this. That’s a sign the broad center of the committee does support these actions and will continue to support them going forward. The basic ideas are broadly espoused inside the committee. So even as personnel changes going forward, this will be seen as the appropriate approach and we will have created a reserve of credibility we can use in subsequent episodes.
Republicans criticized the Fed’s action, though they framed their comments more as an of indictment Mr Obama’s record than a condemnation of the Fed. Lanhee Chen, Mr Romney’s campaign policy director, called the Fed’s action “further confirmation that President Obama’s policies have not worked…We should be creating wealth, not printing dollars.” Republicans may be looking to the day when they control the White House and will be less hostile to stimulative policies than when the principal political beneficiary was Mr Obama.
The Fed is now buying $85 billion worth of long-term securities a month, after including the $45 billion of Treasurys it buys under Operation Twist. Whether that pace rises or falls will depend on how the economy performs. The next logical review will be in December, when Operation Twist comes to an end, and the Fed will have to decide whether to compensate by expanding QE3.
That will depend on whether the policy seems to be working. So far, investors like what they see. The broader stock market jumped 1.5% with the S&P 500 hitting its highest close since 2007. Treasury bond yields actually edged lower (they typically sell off when investors are flocking to stocks) and the yield on the 30-year mortgage backed security plunged 15 basis points. The real test will be the behavior of spending, income and employment. The economy faces several strong headwinds, notably a recession in Europe and the threat of severe fiscal tightening at home through year-end. For that reason alone, a near term improvement in employment seems unlikely.
But thereafter, things look better. Between the ECB’s action last week and the Fed’s today, the world’s two most important central banks are bringing unprecedented resolve to bear on economic growth. The world may one day look back and conclude the first half of September was either a turning point for the global economy, or the final nail in the coffin of the doctrine of central bank omnipotence.
The original article is linked here.