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.

Similarly, with the idea of an open-ended commitment to spending $40 billion every month for an unlimited period, McKelvey believes that sort of language cuts “both ways”.

“What they’re saying is: ‘We’re gonna buy $40 billion a month, but, ya know – stay tuned!’ And you could argue that the ‘stay tuned’ part of that could mean they decide to end it earlier,” he noted.

However nuanced the language of the Fed’s statement was, its modus operandi was pretty clear: by buying up mortgage-backed securities (that is thousands of mortgages packaged into investment products – now back in vogue after a rough period) the Fed has the US housing market, still languishing through its multiyear torpor, firmly in its sights.

By doing so, the Fed wants to bring down mortgage rates to encourage potential buyers. It’s also encouraging banks to originate more mortgages, knowing that they have a captive market in the Fed for shifting those loans off their books.

McKelvey says that, by doing this, the Fed has more than just lower mortgage rates in mind.

“The idea is that if they buy mortgage assets then somebody else who might have otherwise bought mortgage assets is gonna buy something else,” he explained. So, lower rates should stimulate the borrowing associated with those rates – including corporate – which should in turn lift stock prices and stimulate capital investment by publicly-traded firms. Meanwhile, a weaker dollar boosts demand for US exports.

But is a Fed policy of buying mortgages the way to go, given that the last time banks went on a mortgage lending spree it didn’t end all that well?

McKelvey says he sees some, albeit very little, risk in that. “It’s sort of like if you’ve stolen a cookie and your parents have found you out, you’re not that likely to go right back and steal another one.”

But he questions whether the Fed should be working so hard to stimulate mortgage activity in general.

“My concern is that the pro-housing policies of the US government are really a root cause of all of this. They’re not the cause, they’re maybe not even the primary cause. But I think they played a role in setting this whole problem up and I’d just as soon not revisit that,” he said. “But it’s almost treasonous to talk that way in the United States. Home ownership is right up there with motherhood and apple pie,” he added, conceding defeat.

Simon Carswell is away