QE3: The Fed Steps In

The Federal Reserve has decided to further stimulate the economy in a bold and unprecedented manner. The Fed announced, in a 12-1 decision, that it would “[purchase] agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate…in a context of price stability.” These purchases will continue so long as “the outlook for the labor market does not improve substantially.” And even if it does “[A] highly accommodative stance of monetary policy will remain appropriate for a considerable time.”

This action is very different from past Fed actions in that it’s theoretically unlimited in its commitment. In previous quantitative easing the Fed committed to specific dollar amounts. The new policy is limited only to $40 billion per month, for a length of time yet to be determined. The Fed buys bonds from banks with newly created money[1], this reduces the cost of lending, and thus of borrowing, which lowers the cost of consumption and investment. The focus on mortgage-backed securities will reduce the cost of mortgages in particular, stimulating housing demand. There are other channels through which QE stimulates the economy; however, if the banks aren’t willing to lend or individuals/businesses willing to borrow the stimulative effects will be lessened.

On the positive side, this action comes just days after the European Central Bank (ECB) made an unlimited commitment to buy bonds of European countries that are in a debt agreement with the EU/IMF. That the Europeans have made a similar commitment increases the simulative effects of Fed action. Economic policy works best when pursued in unison.

Some people are concerned about the inflationary effects of such policies. There are two basic possible outcomes: either it won’t work, in which case inflation won’t be an issue, or it will, in which case the Fed can withdraw the stimulus and reduce inflationary pressure (more details here and here). Inflation has been historically low and stable since before and especially after the recession. And the Fed doesn’t seem too concerned for now, stating, “If inflation goes above target, we take a balanced approach: bring inflation back to target over time but in a way that takes into account deviations of both [unemployment and inflation] from our target.” The Fed has a duel mandate to keep inflation and unemployment low. Currently inflation is below target and unemployment above target, so this policy is very consistent with the Fed’s mandate.

Now it’s up to the politicians, which isn’t as confidence inspiring. The Europeans need a political solution to escape their debt crisis; the ECB can only buy them time. The United States needs a political solution to the “fiscal cliff”, a detrimental combination of tax increases and spending cuts that will take effect in January. The Fed can only soften the blow slightly. Yet whatever happens, it is good to know that, like a good friend, “the Fed will be there to do what it can.”

This also means that, whoever wins in the upcoming election, any improvement in the economy in 2013 will be due more to the Fed’s actions and not who is in the White House.

1. Basically the Fed "buys" bonds from certain member banks by taking the bonds and adding 0s to the banks' accounts at the Federal Reserve banks.