As expected, the Federal Open Market Committee has embarked on another round of planned asset purchases. In its November 3 policy statement, the FOMC wrote that it expects to buy another $600 billion in long-term Treasuries by the end of 2Q11 ($75 billion per month), in addition to the $35 billion per month in reinvested principal payments from its portfolio of mortgage-backed securities. There has been much criticism of the move in the financial press. Certainly, there are risks in the Fed’s strategy. However, it’s hardly reckless or ill-advised.

 

 

The Federal Open Market Desk in New York plans to distribute its purchases across the following eight maturity sectors based on the approximate weights below:

 

Nominal Coupon Securities by Maturity Range							TIPS
1½ -2½ Years	2½-4 Years	4-5½ Years	5½-7 Years	7-10 Years	10-17 Years	17-30 Years	1½-30 Years
5%	20%	20%	23%	23%	2%	4%	3%

 

Why it the Fed expanding its balance sheet? The economy is in a liquidity trap. Short-term nominal interest rates are near 0%. In a liquidity trap, fiscal policy is more effective at boosting growth than monetary policy. However, with fiscal stimulus unavailable, or possibly negative, monetary policy is the only game in town – and it can be effective, not through increasing the money supply, but by altering expectations.

Quantitative easing is not something that the Fed just made up. It’s textbook economics (granted, at the upper division or gradual level). People have been thinking seriously about liquidity traps and how to get out of them for a long time. That doesn’t mean there aren’t controversies. Plenty of smart people have their doubts. However, comments that quantitative easing is “reckless,” “financial heroin,” or other such nonsense are not based on any theory of monetary policy.

So why is the Fed doing this? Basically, it’s real interest rates that matter. Inflation is too low, making real interest rates too high. The Fed’s actions should lift inflation expectations (and apparently already have). Lower real interest rates are stimulative. And as mentioned, fiscal stimulus is unavailable.

So what are the legitimate worries about quantitative easing? The Fed has relatively little experience with this. The Fed’s first round of asset purchases (mostly mortgage-backed securities) was helpful in stabilizing the financial system, largely because the Fed bought mortgage-backed securities when nobody else would. This second round is different. Many fear that the Fed could be too successful in raising the inflation rate and could possibly generate hyperinflation. However, the key here is the independence of the Fed and its commitment to keep inflation low over the long run. The federal government has been generating more debt and the Fed is taking down some of that debt, but those are separate decisions. In a Washington Post op-ed, Fed Chairman Bernanke wrote that the Fed has the tools to unwind these policies at the appropriate time and “will take all measures necessary to keep inflation low and stable.” Ironically, the commitment to keep inflation low over the long term diminishes the effectiveness of its asset purchases (because the goal is to increase inflation expectations). However, the Fed’s strong commitment to low inflation signals that it won’t let things get out of hand.

One consequence of increased asset purchases (or any monetary policy easing) is higher commodity prices and a somewhat softer dollar. However, a weaker dollar is not the goal (remember that the exchange rate of the dollar is the Treasury’s responsibility, not the Fed’s).

Many worry about a possible bubble in the emerging economies (Latin America, East Asia, etc.). Following the global financial crisis capital flows to these countries picked up. Certainly, this bears watching in the months ahead.

Does the stronger-than-expected Establishment Survey data (from the October Employment Report) change the outlook? Not much. Private-sector payrolls averaged a 136,000 gain over the last three months – that’s enough to keep the unemployment rate steady over time, but not enough to push it significantly lower. Job growth is still much too slow.

In his Washington Post op-ed, Bernanke wrote that “the Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators, and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.”

 

(c) Raymond James

www.raymondjames.com