Quantitative Easing

09 Oct, 2012

Ben Bernanke, Chairmen of the Federal Reserve, has spent much of the last several years in the spotlight of scrutiny of the American economy. With his most recent announcement of round 3 of quantitative easing, it seems as though he is not yet ready to forfeit his place on centre stage.

What is Quantitative Easing?

QE3 is the third round of Quantitative Easing being issued by the Federal Reserve (Central Bank of the United States). Quantitative easing is effectively a process of stimulus in which the Central Bank purchases bonds and other interest bearing securities from the open market on issuance of credit.

Typically, this has two fundamental effects. The price of bonds are forced up by heightened demand, thus driving interest rates down. Under Keynesian economics, these lower interest rates are essential for encouraging lending and borrowing in a stagnant economy. Moreover, it is a form of stimulus that effectively prints money. As mentioned, the securities are purchased on credit. However, because the purchaser is the Central Bank, this credit isn’t backed by anything fiscally tangible, but rather by the ability of the US Economy to create wealth. Money is therefore injected directly into the economy as a form of stimulus. This tends to devalue the currency, and often has the effect of increasing rates of inflation.

The Significance of QE3

September 13th saw the Federal Reserve pass QE3 in a vote of 11-1. Although the rumor mill had been turning for weeks leading up to its release, few could have anticipated just how remarkably different this new round would be for the Fed.

QE3 is structured on 3 underlying components, the first of which is the continuation of the “Operation Twist” policy carried over from QE2. This policy was essentially the sale of short term bonds for the purchase of long terms bond to the tune of $45 Billion a month. QE3 notably extends the policy through until the end of the calendar year. In addition, the Feds announced plans to purchase $40 Billion in Mortgage Backed Securities (MBS) per month for the same extended period through December of this year. This will be a continued effort to lower effective mortgage rates. The figure of $340 Billion in purchasing, at $85 Billion per month over 4 months, is seemingly modest when compared to past rounds of QE (QE2 included over $850 Billion in treasury purchases).

The most crucial component, however, is the open-ended term on which the Fed has issued QE3. Bernanke has made it clear that unless there is a significant turn-around in the US economy over the course of the next 4 months, MBS purchases will continue for as long as is deemed necessary with the distinct possibility of raising the cap above $40 Billion. Moreover, the plans outline a pledge to keep interest rates extremely low (hovering around 0.25%) well into 2015, tacking on an additional year to the term outlined in QE2. This is the first time the Fed has committed to lower interest rates beyond purchasing plans.

Reception and Predictions

In an unlimited commitment to QE3, the federal reserve has taken an earnest approach to improving the labour market. “The Fed is going use all the power it can muster to return the U.S. economy to noninflationary full employment,” notes Dr. Sherry Cooper, Chief Economist with BMO Financial Group. However, while the US Employment figures will no doubt invade headlines for the coming months, it is the “noninflationary” qualifier that has many analysts talking.

Bernanke explicitly notes that the priority of QE3 lies with both “price stability” and “maximum employment.” QE3 allows the Fed to assume a reactionary position with respect to inflation. If the US Dollar were to devalue, the unemployed would be the first affected in the fragile consumer market. However, if the dollar were to strengthen, manufacturing sectors would have tremendous difficulty keeping growth figures out of the red. Bernanke claims that the open-ended nature of QE3 will allow the Fed to limit inflation by withdrawing its policy and shrinking its balance sheet in a “deliberate and orderly way.”

What This Means for the Investor

Short-term response to QE3 has been largely underwhelming. A look at market performance in the days following Bernanke’s announcement shows a jump that is significantly dwarfed by those associated with QE1 and QE2. This is especially noteworthy when considering that the unlimited nature of QE3 was well out of the scope of predictions leading up to its release.

With the long term stability of the US dollar now in question, investors will likely be looking to capitalize in one of two ways. While the most direct is a substantial reduction in US Dollar holdings in favor of currency set in a commodity focused market, many are cautious given the uncertainty looming in Europe. With the Euro out of the question, expect substantial attention from FX traders to be directed at Canada and Australia. For those unwilling to venture into the currency market, investors can shore up portfolios with securities in substantial multinationals. A diversified operations base, and subsequent revenue stream, will limit vulnerability to the effects QE3 will likely have on domestic labour, manufacturing, and inflation.

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