Friday, 14 September 2012

Mike Lenhoff: Why has the Fed opted for more QE?

Image: The Fed's HQ
Yesterday, the Federal Reserve demonstrated yet again how the major central banks are exercising the latitude they have, and are prepared to take, for policy making within their respective mandates. The FOMC introduced its third QE programme (QE3), an open-ended initiative whereby the Fed will purchase US$40 billion monthly until it views the chances of its mandate being met as having greatly improved.

The FOMC also offered more forward guidance, a tool it has been using to great effect in influencing interest expectations. It made the point that the ‘Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens’. The Committee has now extended this message to mid-2015, the time horizon for which ‘exceptionally low levels for the federal funds are likely to be warranted’.

Why has the Fed opted for more QE? First, because, in keeping with its mandate of maximum employment with price stability, the Fed reckons that the economy is growing at a pace that prevents the unemployment rate from falling in a satisfactory manner towards its long run objective. Also, inflation is below the 2 percent level it associates with long run price stability. QE3 is not necessarily because the Fed thinks a recession is coming. It is because it thinks the pace of growth is just too slow for the good of what the Fed Chairman described recently as a stagnant labour market and it worries that, with the prevailing uncertainties over US fiscal policy and also Europe, the risks for the economy are on the downside. The second reason for QE3 is that the Fed believes that non-traditional policies work.

An open-ended QE3 programme focusing on mortgage-backed securities should help keep mortgage rates down at their historical lows for a long time, so helping the housing market to continue recovering and helping to boost aggregate demand through various ways. Operation Twist will be maintained to the end of the year so this should help to keep yields at the long end of the Treasury market down.

Bernanke’s message is not just for the markets. It is also aimed at US policy makers. The Fed is doing what it can to support the economy but there is always a risk and cost associated with each new endeavour. This does not mean that the time has come for Washington to give Bernanke the boot. Instead the time has come, indeed, is long overdue, to apply the boot where it is needed most, that is, in sorting out the fiscal cliff and fiscal policy generally. The message from the Fed to Washington is - get on with it!

The FOMC’s policy stimulus comes after what has been a big two weeks for markets. It started with the ECB’s new Outright Monetary Transactions (OMTs) aimed at supporting eurozone sovereign debt markets, which is good for the banks and then came the favourable ruling by Germany’s Constitutional Court and also the Dutch election. The latter is likely to lead to a stable coalition supporting the eurozone.

So maybe the markets are justified in responding as they have. Europe’s difficulties are far from over but the crisis is now likely to be subdued. Meanwhile the Fed is doing its bit to keep the US economy growing and creating jobs. With a little more help from the emerging world, the backdrop might even begin to look rosier again.

Mike Lenhoff
Chief Strategist

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