Fed still in pursuit of elusive economic recovery

THE BOTTOM LINE:The Federal Reserve is making another stab at it.

Almost four years after the first round of quantitative easing, known as QE1, was announced, Fed chairman Ben Bernanke launched QE3 last week – the third incarnation of a monetary policy-driven, kick-start for the US economy.

The first two attempts didn’t quite do the job of spurring economic growth to the point where unemployment would start to come down significantly. Unlike most other central banks, whose sole, stated aim is to maintain “stable prices” (that is manage inflation – not too much, not too little), the Fed has a so-called “dual mandate” whereby it is also supposed to gear its policies towards achieving full employment. With that in mind, there has been huge pressure on Bernanke to act.

This time was different though. As Harvard economist (and co-author of This Time Is Different: Eight Centuries of Financial Folly) Ken Rogoff noted: “The Fed took a huge step towards implementing QE as prescribed by academic models: open-ended with the aim of achieving a clear goal.”

In other words, unlike QE1 and QE2 where the Fed put a cap on the amount of money it would pump into buying up US treasuries (in order to keep interest rates near zero and encourage investment in growth-oriented assets), with QE3 the Fed simply said it would spend $40 billion (€31 billion) every month.

This would enable it to buy up mortgage-backed securities until it was clear the economy was roaring again.

Don’t stop ’til you get enough, Michael Jackson might have said.

If Rogoff had one criticism of QE3, it was that the Fed “still fell short of stating a goal of letting inflation rise above target for an extended period until the economy has escaped its liquidity trap”.

“Instead, they preferred to let investors infer a new higher tolerance for inflation indirectly, by stating that they would keep going until the unemployment picture significantly improves,” he said.

This “inference”, as Rogoff describes it, is key to understanding how the Fed and markets interact. Few statements are pored over so much as those made by the Federal Open Markets Committee. The language used in every statement is examined to within an inch of its life, parsed 64 different ways, to the point where every word is expected to mean something.

A former macro-economist at Goldman Sachs, Edward McKelvey, said he for one was “surprised” by the language the Fed used when it said it would keep interest rates low for several more years.

“It was a lot stronger than I anticipated,” he said, citing the Fed’s commitment to maintain “a highly accommodative stance of monetary policy . . . for a considerable time after the economic recovery strengthens”.

“What they said was: ‘Look, we’re planning to keep monetary policy on an easy track, even after the economy starts to strengthen.’ And so that sort of tells you that this is a policy decision meant to be supportive of growth, rather than just simply a reflection of a weak growth outlook,” he explained.