QE3 – What Does It Mean for Me?

September 14, 2012

On Thursday, Bernanke and the Federal Reserve introduced a third round of quantitative easing. Quantitative easing (QE) is an effort to try to reduce unemployment through the purchasing of mortgage-backed securities. If you’re confused about the link between buying mortgage bonds and unemployment, you’re not alone.

The U.S. economy continues to grow, slowly. We believe that the slow and steady growth will continue, with limited likelihood of acceleration or risk of renewed recession. Since World War II, the economy has grown on average about 3% a year (economists call this “Trend Growth”), but the current growth rate is only about 2%. That might not sound like a big difference, but it is. Consider that $10,000 invested today at 3% turns into $18,061 after 20 years, whereas the same amount invested at 2% turns into only $14,859. The difference between current growth and trend growth is called the output gap. The output gap today is quite large at 1%.

Federal Reserve Board Chairman Ben Bernanke and his team are charged with two goals: maintaining price stability (controlling inflation) and providing for full employment (keeping the output gap as small as possible). For the moment, inflation is under control at around 2%, as measured by the Consumer Price Index. Economists believe that if the output gap were closed—meaning the economy grew at around 3%—the United States would reach full employment, which is estimated at an unemployment rate of about 5%. Unemployment will never reach 0%; there will always be new entrants into the job markets, companies laying off workers, people changing jobs, etc. The unemployment rate is currently at 8.1% and given the August Jobs report, new jobs are being created slowly. Bernanke is laser-focused on closing the output gap and driving down unemployment. But how can the Federal Reserve do this?

Normally, the Federal Reserve (also referred to as the Fed), lowers short-term borrowing rates to stimulate investment and spending during periods when unemployment is above 5%. Currently, however, interest rates are hovering near 0%. The Fed needs to turn to other, less traditional tools to drive down unemployment. When interest rates are near 0%, the only major tool left for Central Banks is to increase the money supply, called quantitative easing or QE. Increasing the money supply theoretically should further drive down the costs of borrowing for investing and spending by further lowering short-term interest rates and raising future expectations about inflation. Practically speaking, the Fed increases the money supply by buying bonds issued by the Treasury in exchange for newly printed money. The Fed has committed to buy bonds twice since the 2008 Credit Crisis, in QE1 and QE2; across both operations the Fed purchased over $1.6 trillion of U.S. bonds! Whether because of these QE operations, or other phenomenon, interest rates did fall dramatically, but inflation has not risen as desired.

Now the Fed has laid out its commitment to engage in another round of money supply growth, QE3, to help further reduce the unemployment situation. The Fed stated that it will begin purchasing $40 Billion of mortgage bonds a month.  All together, these measures will increase the Fed’s holdings of longer-term securities by about $85 billion each month for the stated purpose of “putting downward pressure on longer-term interest rates, supporting mortgage markets, and helping to make broader financial conditions more accommodative.”

The problem is that while the money supply is expanding quickly, it doesn’t look like businesses and individuals are taking advantage of the lower interest rates to invest and spend. Cash on companies’ balance sheets is building up and consumers are shedding debt. The Fed can keep printing more money, but until businesses and individuals want to use the money, unemployment isn’t going to fall. Bernanke’s logic now seems to be that if he prints enough money today, we will all be convinced of higher inflation—that is, rising prices—tomorrow. If we expect prices to rise tomorrow on boats, cabins, cars, and dare we say houses, then we will buy those things today, which will spur demand, which in turn creates new jobs and reduces unemployment. In fact, in the September statement, the committee stated that it will likely hold rates near zero at least through mid-2015, believing that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” There is a risk, however, that because the increase in prices can’t be controlled, inflation could rise to levels that lead to uncertainty, which could potentially destroy the chances for increasing demand.

We don’t think Bernanke is in an enviable position. He has the task of trying to get people and businesses to buy and invest more. He has only one tool left: trying to convince us that we will pay more later if we wait to make our purchases. We fully expect Bernanke to keep trying to bring down the unemployment rate, and we hope he succeeds. We have our doubts, however, about how much the Federal Reserve can do to make us want to spend more. After all, the things that make most of us want to spend more aren’t related so much to future prices, but more to new cool things to buy (think iPads), how secure we feel in our job, how much income we have coming from our investment portfolio, and generally how good we feel about our future prospects.