Will the Fed Initiate QE3?

Will the Fed Initiate QE3?

As Europe's refusal to implement long term solutions to its fiscal crisis continues and U.S. economic data remains weak, speculation is growing that the Federal Reserve will initiate QE3.

With the newest chapter in the European debt crisis unfolding and Spain’s sovereign debt yield rising over 7%, the head of the European Central Bank (ECB), Mario Draghi, declared his intention to “do whatever it takes” to save the euro.  This pledge had a remarkably calming effect on the bond markets and yields for both Spain and other European countries struggling with high borrowing costs, most notably Italy, fell significantly.  His announcement, coupled with those of other European political and financial leaders, created a high level of expectation amongst investors that immediate, forceful action would be taken to help provide a long term solution for the crippling effects of unsustainable sovereign bond yields.  Those expectations, perhaps unrealistic, were quickly replaced by disappointment as it became clear that no new policy initiatives would be implemented in the short term.[1]

            This lack of immediate action, the lengthy list of possible impediments to action in the future and the ECB’s decision to leave its benchmark interest rate at 0.75%, sent equity markets tumbling and led to a sharp rise of yield levels in the sovereign bond market as Spain saw its 10 year bond yield shoot back over 7% once again.[2] Europe’s inability -or unwillingness- to come to grips with their ongoing fiscal crisis constitutes a tremendous drag on the global economy.  This, coupled with weak U.S. economic data, has many speculating that the Federal Reserve will initiate a third round of quantitative easing, with the majority of Wall Street economists and primary dealers believing that it could act as soon as September.  The U.S. economy has slowed in the first half of this year, with the second quarter figure of 1.5% representing a drop from the 1st quarter number of 1.9% and a sharp decrease from the 2011 4th quarter total of 3%.  Unemployment remains high as well, as the U-3 number rose to 8.3%, despite the economy adding 168,000 jobs in July. Some dealers believe that the Federal Reserve will try other, alternative measures first, such as announcing that overnight interest rates won’t be raised until mid-2015, which would represent an expansion beyond the current projection of that rate remaining at its current level of near zero until late 2014.[3] 

The Federal Open Market Committee (FOMC), the body responsible for conducting the transactions designed to increase or decrease the money supply and through that money supply manipulation influence domestic interest rate levels, announced no new policy initiatives after its latest meeting.  It did, however, acknowledge that economic activity is slowing and that further action might possibly be needed in the future.  “The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability." The FOMC also reiterated that interest rates are likely to remain “exceptionally low” through late 2014 and that “Operation Twist”, the sale of short term Treasury securities and purchase of long term Treasury securities, would continue through the end of the year.[4]

The expectations for additional stimulus through another round of quantitative easing, or QE3, now shifts to the Fed’s September meeting.  If QE3 is implemented another question will remain to be answered: will it work?  Market and asset prices would most likely go higher and interest rates lower, but it is unlikely that such an action will provide much stimulus to the economy.  David Shulman, senior economist at UCLA’s Anderson Forecast says: "The markets want it, the markets will probably rally a little bit on it, but then I don't think it will have any oomph," he says. "That's my personal view. I don't think it will do a whole lot. ... The system is totally flooded with liquidity."[5]

Mr. Shulman has a cogent point.  Decreasing interest rates and increasing liquidity will accomplish little in an environment where the focus is upon deleveraging, not on taking advantage of low interest rates to bring on more debt.  Perhaps lower mortgage rates will continue to spur mortgage refinancing activity, but those borrowers most desperately in need of access to these low rates are also those likely to have difficulty in getting approved given tighter lending standards.  Wall Street is more likely to benefit from QE3 than Main Street.

Image: Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Reviews

  • Adam

    August 07, 2012

    I will continue to refinance. A lot of people can't refinance, but a lot of people still can. Going to look at a 10 year if rates go down further. Best way to work off the debt in this country.

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