[Update – Fed Undertakes QE3] The Federal Reserve has confirmed market expectations of a new round of quantitative easing, known as QE3. The new round of easing will be done by expanding its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month. The focus, as discussed in the update below, is to boost economic growth and reduce unemployment. Economic growth slowed to a 1.7 percent annual pace in the second quarter from 4.1 percent in the final three months of last year, with a median analyst forecast of 2.1% growth for 2013. Unemployment is expected to remain around 8% for the next 6-12 months.
As a side effect of QE3, interest rates are expected to remain at record lows through 2015. This pushed investors towards higher returning equity and commodity markets, like the stock market which has hit multi-year highs in anticipation of QE3. Gold and Oil prices were also up. The US dollar fell against the specter of an extended low interest rate environment.
“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,” the Federal Open Market Committee (FOMC) said today in an official post-meeting statement
The Fed said it will continue its program to swap $667 billion of short-term debt with longer-term securities to lengthen the average maturity of its holdings, an action dubbed Operation Twist.
QE (quantitative easing) is essentially the printing of money and the addition of liquidity into the markets so that stock (and other asset) prices are given an artificial boost. Federal reserve chief, Ben Bernanke believes that by pulling up stocks, the masses will feel richer and spend more on consumer goods, thus lifting up the economy. This is based on Karl Marx’s reflexivity theory (George Soros basically paraphrased Marx) in which by turning the small wheel (stocks), you can turn the big wheel (economy), which in turn will come back and turn up the small wheel (stocks). Bernanke subscribes to such a theory, and he wants QE to lift up the small wheel (stocks), which he hopes will lift up the big wheel (the economy).
But after two successive rounds of QE (QE1 in 2009 and QE2 in 2010), it has become crystal clear that quantitative easing doesn’t work nearly as well as theory says it should! In the short term, QE can pull up stocks and the economy, but in the long term, the economy is going to go where it’s going to go, regardless of how much liquidity the Federal Reserve is pumping into the economy and stocks. Everyone has now recognized that the economy is slowing down (including Congress), and everyone knows that the Federal Reserve has only one bullet left: QE3. QE is like a medical drug – take it once, and you’ll heal very quickly. But every time the disease comes back, you’ll need to take bigger and bigger doses of that drug, and each time you take the drug, the drug becomes less and less effective until eventually, the drug is useless. QE3 is the last round of QE because everyone knows that QE4, 5, 6… will be pointless.
Will QE3 be announced at the next Federal Reserve meeting? Will the Fed shoot its final bullet? Out of the 11 Federal Reserve officials, 10 have already voted “yes”. However, the decision ultimately lies to the Fed Chairman, Bernanke, who has veto power. Right now, the commodity and stock markets are stalling and waiting to see what will happen at the August Fed meeting. Here’s what I think about the chances of QE3 being announced at the August meeting.
Factors Influencing Bernanke’s Decision
- Romney has stated that, if elected president, he will not renew Bernanke’s term as Federal Reserve Chairman in January 2014. Meanwhile, Obama is a great defender of Bernanke, who will do anything in his power to ensure that Obama wins this year’s election. Historically speaking, the stock market has had a great influence on electoral results – the administrations at the time usually win the re-elction if stocks do ok during election time, and administrations at the time usually lose if stocks fall during re-election time. This means that Bernanke needs to ensure that stock prices don’t fall from now until November 4 2012.
- Everyone, including Bernanke himself, knows that this is the Fed’s last bullet. If he shoots this bullet (initiates QE3), he has no more weapons on his arsenal should the economy and stocks tank hard.
- Everyone is looking towards Bernanke. Congress has already said that the economy is slowing down & that the “Fed is the only game in town.” If Bernanke doesn’t initiate QE3 now, it’ll seem like he’s behind the curve, which is bad PR for Bernanke.
Why He Will Initiate QE3 at the August Meeting
- Bernanke must prop up stocks from now until the election. In addition, every knows that the economy is already slowing down, so Bernanke will look bad (from a PR standpoint) if he’s too slow in reacting.
- If he’s going to initiate QE3, he can’t wait until the September 12 – 13 meeting. Markets usually take 2 – 3 months to react to QE, which means that should he initiate QE3 in September, it won’t have any positive effect on stocks until the elections are already over. This leaves Bernanke with one choice: announce QE3 on August 1.
Why He Won’t Initiate QE3 At All
- Everyone knows that this is Bernanke’s last bullet, so once he shoots that last bullet, all the short sellers might sell on the news. So instead of propping stocks up, QE3 might just cause stocks to tank. Bernanke knows this too, which is why he’s hesitant about initiating QE3.
- Bernanke’safraid that QE might cause commodity prices to rise (which has happened in the past), which is bad for the economy because the cost of everything goes up. Already going up, oil prices will rise even more should QE3 be initiated. This will send shock waves through an already frail economy.
Whether Bernanke does or doesn’t initiate QE3 is uncertain, and if he does, what the market’s reaction will be is even more uncertain. I hate investing in markets like this, when you shouldn’t really be doing anything because the decision (QE3) can go either way. You never know – Bernanke might wake up all happy one day and initiate QE3, or if he’s in a down mood, might not initiate QE3.
This was a guest post from Tony, an individual macro investor, ho blogs at A Young Investor where he teaches other investors how to invest in stocks, commodities, and currencies from a macro, fundamental, and technical perspective.