The Impact of QE3

In early September, the Federal Reserve announced a third round of quantitative easing (QE3), which essentially means printing money to buy financial assets to keep interest rates low. While QE3 was widely expected, the language in the announcement — stating that asset purchases would continue until the recovery was firmly established — was an unexpected, positive surprise to the market, with the stock market rising substantially in subsequent days. This is, without a doubt, a change in tone and stance by the Fed. What was the reasoning behind its aggressive action?

In normal times, the Fed tries to support the economy and unemployment through countercyclical interest rate policy, lowering the federal funds rate when the economy isn’t doing well and raising the rate when the economy is overheating. This is all done within the context of keeping the rate of inflation under control (and, of course, doing what it can to help the economy avoid deflation). So, the Fed has a “dual mandate” of being supportive of the economy, particularly helping keep unemployment low, while also keeping inflation under control.

In abnormal times, which certainly characterizes the period from basically 2007 to now, the Fed has other tools at its disposal. For example, it can act as a lender of last resort, taking financial market risk when other investors won’t. We saw such actions in 2008 and 2009 when credit markets quit functioning properly due to massive losses on levered, non-agency mortgage-backed securities within the banking industry.

More recently, the Fed has turned to quantitative easing. The logic behind it is that the main way to bring interest rates down once the federal funds rate is zero is to buy intermediate- and long-term fixed income securities with printed money.

The belief is lower interest rates will push investors toward taking more risk (such as extending loans to individuals and businesses and buying riskier bonds, therefore lowering credit spreads) and buoy stock prices. This, in turn, can create a wealth effect that encourages these investors to spend more since they have more wealth. Further, it’s likely the Fed is pursuing QE3 to counterbalance the possibility of contractionary fiscal policy in early 2013. Note, however, that a recent research paper questions whether quantitative easing produces any of these purported benefits.

While potential benefits have been discussed, there are risks of such policies. For one, the Fed is, to a large degree, in uncharted territory. How do you reduce this degree of stimulus in an orderly manner while making sure inflation doesn’t get out of control? Should the securities purchased through the various quantitative easing programs be sold first? Should the federal funds rate be increased first? Or should both actions be taken at the same time? What about the moral hazard created by the markets perceiving that the Fed will always ride to the rescue? Finally, while low interest rates may benefit some, it harms others, such as public pension funds whose liabilities increase when interest rates fall.

It is important to remember that in times of low interest rates such as this, institutions should not keep a large portion of cash or very short-term fixed income. Cash or short-term bonds for liquidity can be prudent, however; staying short in anticipation of rising rates is guaranteed to be eroded by inflation. Furthermore, the Fed has already indicated that rates will remain low until at least mid-2015. Institutions also should not try to increase yield by denigrating credit quality. Many institutions were hurt in late 2007 and early 2008 by taking on riskier fixed income to increase yield as they came out of the low-rate environment of 2004.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2012, The BAM ALLIANCE

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