Yesterday Ben Bernanke, chairman of the U.S. Federal Reserve System, announced that the central bank is going to continue its “quantitative easing” strategy until significant improvement in labor markets reduces unemployment. An extraordinary pronouncement from the central bank, this move signals Bernanke’s commitment to action until the U.S. economy recovers and then some. Evidenced by the rally in U.S stock markets, the Fed’s decision will do much to restore much-needed investor confidence and promote economic activity throughout the economy. However, this may also suggest that the Federal Reserve has exhausted its arsenal of policy options to influence market conditions, meaning that a deadlocked Congress will have to step up and support the Fed’s monetary policy with appropriate fiscal policy.
So What Exactly Is The Federal Reserve Planning To Do?
For those unfamiliar, “quantitative easing” is a process whereby the nation’s central bank purchases predetermined quantities of assets from commercial and investment banks. As open market operations go, this type of move is reserved for when increasing the money supply through lowering interest rates doesn’t generate enough economic activity and new investment.
According to The New York Times, the Federal Reserve plans to purchase large quantities of mortgage-backed securities and “other assets” to encourage borrowing and investment. These purchases will continue until unemployment declines substantially. From what we know now, the plan is as follows:
- First the central bank plans to buy $23 billion in debt-securities (bonds, asset-backed securities and the like) by the end of September.
- Then, the Fed plans to buy up to $40 billion in debt-securities each month, with targets announced at the end of each subsequent month.
According to Bernanke, the Federal Resrve is looking to see “Ongoing, sustained, improvement in the labor market. It is not a specific number we have in mind.” In addition, the central bank plans to continue exchanging short-term securities for long-term securities which would bring total purchase amounts to around $85 billion a month.
What Does Additional Stimulus Mean For The Economy?
For U.S financial markets, continued bond purchases and low interest rates will provide the most accomodating (from a monetary standpoint) conditions for investment, even more so than QE 1-2. Purchasing asset-backed securities and other “toxic” investment products helps clear debt and liabilities from the balance sheet of America’s financial institutions while supplying them with cheap capital. Removing anemic debt securities and injecting new capital make investment and commercial banks more attractive for investment, providing a solid foundation for the banks themselves to invest in the general economy. For investors, the most important aspect of the Fed’s decision is the turnaround in market confidence in the central banks’ commitment to supporting long-term economic growth, which creates very favorable conditions for investment across asset classes.
However there is also a point of concern. Bond purchase programs like Q.E. are typically last-resort options for central banks, because taking on short-term debt (even at near-zero interest rates) can be problematic in an economy already troubled by debt. Guaranteeing bond purchases until labor markets turn around may be a sign that the Federal Reserve is out of options for providing additional stimulus to the economy. Between the Troubled Asset Relief Program (conducted with the U.S. Treasury), lowering long-term interest rates to near-zero levels, and two rounds of easing, the Federal Reserve has taken unprecedented steps as a central bank to combat the effects of the housing market collapse and contractions in U.S. credit markets. But this move is a last resort of last resorts, as Bernanke himself stated that “Monetary policy, particularly in the current circumstances, cannot cure all economic ills.”
With America’s central bank going all-hands-on-deck with Q.E the further recovery efforts must come from federal legislators in Washington, who can use fiscal policy to support the Federal Reserve’s monetary policy. However with the gridlock over spending, taxation, and fiscal policy issues between the Democratic Senate and the Republican House, the arrival of such initiatives is unlikely for the time being. If Democrats can hold the White House, it’s likely that Bernanke will be able to continue his bond purchase program unhindered, but it’s also more likely that little ground will be covered on additional fiscal policy. If Republicans capture the White House, Bernanke’s bond purchases could be in jeopardy, based on that party’s positions around debt and spending reductions from federal agencies, the plans to audit the central bank, and considerations of a gold standard to restrict the ability to expand its balance sheet.