QE3 – A Brief Analysis

This is an interesting statement from the FOMC.  They announced QE3 in the form of $40B per month MBS purchases.   This will bring total monthly purchases to $85B per month.  They also said rates were likely to stay low “at least through mid-2015″.   It’s the wrong policy approach in my opinion.

First of all, QE is a simple asset swap of reserves for bonds.  In this case they’ll be buying MBS.  So it’s important to understand that the net financial assets of the private sector are unchanged here.  QE1 was different.  What the Fed did was essentially put a floor under assets that were selling at 30-40 cents on the dollar.  This was hugely bullish for the banks and the broader economy as it helped stabilize the economy enormously.   The recent QE’s have had a far more muted effect as these assets are all selling at par or above.

It’s also important to squash the myth that QE helps “monetize the debt” or fund the government.  This implies there is not enough demand for government debt.  This is patently false.  The US government uses the banking system in the USA to fund itself.  Primary Dealers are required to bid at auctions.  The only environment this wouldn’t occur in is a hyperinflation or an environment where inflation was very high.  This environment of de-leveraging and deflation is not remotely similar to such a situation.  Regardless, demand for government bonds has been very high throughout the crisis. As the world’s dominant output nation, US Treasury Bonds continue to appear far safer than most other bonds.  So the idea that the USA needs the central bank to fund its deficit flies in the fact of a mountain of evidence saying otherwise.

Now to the meat.  Remember, QE “works” in several different ways.  The primary way it works is by influencing interest rates and influencing credit channels, however, this policy doesn’t target rates as most monetary policy does.  Instead, it targets a size of purchases.  This doesn’t help set rates.  And at the end of the day central banks are price manipulators.  They manipulate prices by setting prices.  Not by letting the market decide price.  This strategy does not set prices so its impact on interest rates is far more muted than it could be.  That means the impact is muted.

The other primary transmission mechanisms are through portfolio rebalancing and so-called “wealth effects”.   It’s clear that QE has a powerful psychological impact as most people think it’s “money printing” and causing inflation.  This causes temporary market distortions.  The wealth effect theory is intriguing, but equally misguided.  Market prices reflect the future cash flows of underlying assets.  They do not reflect the future buying of central banks.  So this sort of policy puts the cart before the horse.  It is like a corporation who reinvests no money back into its operations and instead jams its stock price higher thinking this will impact the underlying assets.  It’s completely backwards thinking.

My general opinion here is that this was a big mistake by the Fed.  As I mentioned earlier in the week, I would have held off if I were running the ship.  Now the Fed is at risk of having the tide come in and everyone realizing they’re swimming naked.  They’ve essentially bought high with the S&P trading near its all-time highs.  So an economic downdraft and a subsequent market decline has the potential to severely damage the impact of future Fed policy.  I personally would have held off entirely.  Or if I were going to implement the policy I likely would have set long rates at 0.5-1.0% and left the purchases open-ended.  Clearly they did neither.  So now we’ll see if the Fed is indeed swimming naked.  I fear they are now at risk of exposing themselves.

The full release is below:

Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months.  Growth in employment has been slow, and the unemployment rate remains elevated.  Household spending has continued to advance, but growth in business fixed investment appears to have slowed.  The housing sector has shown some further signs of improvement, albeit from a depressed level.  Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  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.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.  In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.  Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted.


Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Equities about to explode upwards. Rich people in the market get richer, poor, what’s left of the middle, and labor get the shaft, even though they will look on and see a rising stock market and take it as a sign of economic rebound. The oligarchy controls the money supply indefinitely, wonder how much longer this goes on until people realize what’s up – my guess is never.

  2. Cullen,
    I appreciate your assessment of the Fed’s use of QE, but your recommendation of setting “long rates at 0.5-1.0% and leaving purchases open-ended”, would be a complete disaster. First, the underfunded nature of pensions would explode higher, for it would be impossible to match liabilities with assets either by mandate or on a risk-adjusted basis. Second, insurance costs would skyrocket, or, companies would just walk away, causing individuals to self-insure. I ask you, how can an individual manage the risk that an aleatory contract provides, when insurance companies cannot match assets with liabilities on a risk adjusted basis in a ZIRP, that extends in to perpetuity? The FED announcement of a ZIRP of 2015 and most likely beyond is and will cause a negative feedback loop, the likes of one we have never seen before. I wonder if you have tried to quantify the negative impact to interest income by savings, for each dollar the FED uses in QE. As always, thank you for your work.

  3. I largely agree with your interpretation of the transmission mechanisms of monetary policy, but I’d like to offer some food for thought. Or, why I’m substantially more optimistic about the Fed statement than you:
    1) The Fed is directly targeting long yields (well okay intermediate and indirectly longer-term). That’s the whole point of saying interest rates will be essentially 0-0.25% until 2015. It’s almost equivalent to saying “We’re setting the rate on all Treasuries maturing before and up to July 2015 to a 0-0.25% yield. And we’ll honor that price until they mature.” This really is the only way for the Fed to target long(ish) yields. In any other direct targeting scheme, if there was any substantial risk that the Fed would increase the overnight rate before maturity, the private sector would avoid such Treasuries. Why? because they could do strictly better by holding and rolling over the shortest term T-bills. The Fed would have to buy up the nearly all of the relevant longer duration treasuries (to honor the unjustified price), which would wreak havoc on the financial system.

    2) Something like a wealth effect is clearly real, at least if you believe we’re in a balance sheet recession. I agree with you and cringe at the idea of inducing people to pay more than the present value of future cash flows for an asset. But I believe the Fed’s idea is not to get people to overpay for the asset but to boost the present value of the asset itself. And the Fed is rightly focusing more on housing than on the stock market.

  4. Cullen Roche: “Now the Fed is at risk of having the tide come in and everyone realizing they’re swimming naked. They’ve essentially bought high with the S&P trading near its all-time highs. So an economic downdraft and a subsequent market decline has the potential to severely damage the impact of future Fed policy. I personally would have held off entirely.”

    Great comment on the Fed!

  5. You should realize that the Fed’s action confirms everyone’s belief that the Fed is intent on destroying the value of the dollar in its quest to stop deflation. Therefore, everyone is trying to protect themselves from the decline in the dollar by buying gold, foreign currencies, and stocks and paying off debt. So the Fed’s actions are actually making things worse.

    The Democrats are intent on borrowing, taxing, and spending, so people see debt accumulating to the point that default is inevitable. As people have less and less trust in the government both on the spending side (Congress) and the dollar side (the Fed), they save more, reduce their debt, and hunker down for the storm. Combine all of this with the decline in demand because of demographics, and you have an economy in Depression.

  6. QE3 will demonstrate that the Fed’s attempts to create a robust economic recovery was a failure. Public debt to GDP is 105% and climbing. Household income is falling. 80M Baby Boomers are headed into retirement and creating a consumer spending downdraft. This is the perfect storm.

  7. I have disagreed with some of your views in the past, but I think you are spot on on your critique of QE3 and its real mechanism – very good article, a must read.

    While I think that you probably don’t want to take the issue to the controversial side, I need to mention the very real possibility that Bernanke effectively made a backdoor bailout of European banks with QE3, via primary dealers (european ones, including “taunus”, DBs subsidiary, and the french banks).

    Recall that france’s gov’t mortgage lender was nationalized recently, with nary a word in the media and no spike in european bank liquidity measures such as euro basis swaps – full manipulation.

    The problem in Europe is much worse than it currently is being sold to us, I suspect. From here until Obama’s election, it would have been difficult to justify QE closer to elections, it had to be done now. The problems in Europe require ever increasing Dollar funding for banks and the current “invisible” arrangements to provide that funding were probably becoming insufficient.

    Bernanke would never be as naive to waste a bullet under the current US employment and inflation figures, not to mention the horrible timing. It is in contradiction to his “market floor” psychology and effective use of the media to set monetary policy – he is now very exposed and his arsenal is clearly less impressive in the eyes of the players as he has shown his ace.

  8. Cullen,

    I would love you long time if you added RSS feeds for the comments sections. Or used DISQUS.

    • Sigh, mispost. I also wouldn’t mind an edit button – something that DISQUS provides.