The U.S. Federal Reserve announced yesterday its most aggressive plan to arrest lethargic growth in the U.S. economy with its third round of quantitative easing (“QE3”) since the financial crisis began in 2008. This comes immediately on the heels of the European Central Bank’s (“ECB”) own initiative last week to launch its first quantitative easing exercise, promising unlimited bond purchases in an attempt to contain its three year old sovereign debt crisis.
Similar to ECB’s declaration of unlimited bond purchases, the U.S. Fed is promising open-ended purchases of mortgage-backed securities in the open market until its objective of stimulating job creation and growth in the economy is met.
The aggressive set of measures sent the market into a dizzy. The S&P 500 rose 1.6 percent to 1,459.99 on Thursday to its highest level since 2007, while Asian markets opened on Friday morning in positive territory for the seventh day in a row.
By selectively targeting mortgage-backed securities, this announcement represents unprecedented support to the housing sector, driving Fannie Mae mortgage yields to its lowest level on record at 2.18 percent and sending Freddie Mac shares up 7.14 percent.
There are essentially three components of the Fed announcement that investors should understand. First, the Fed is promising to purchase $40 billion worth of mortgage-backed securities every month until it decides that the job creation process is back on track. This means that the agency will print an unlimited amount of money for an infinite amount of time until unemployment rates improves dramatically. Bernanke, the Federal Reserve President, is betting that by artificially suppressing mortgage rates, he can not only jump-start recovery in the housing market, but also leave consumers with more cash as they apply for mortgage refinancing at historically low rates.
Second, the Fed is committing to leave its target interest rate at zero until at least 2015. Short-term yields of Treasuries can thus be expected to remain at or close to zero in the near term as the Fed continues to hope that a low interest rate environment will drive banks to restart lending to consumers – a key driver for economic growth.
Third, this $40 billion of extra liquidity in the monetary system is in addition to the $45 billion the Fed is spending each month under the Operation Twist program expiring in December this year. The program uses proceeds from shorter-term bonds to purchase longer-term securities in order to lower yields of long-term Treasuries. Combined, the two operations represent a commitment of at least $85 billion a month by the Fed.
While the extra liquidity is not fueling inflation concerns right now, investors should be keenly aware that previous quantitative easing exercises have led to rising commodity prices – an issue that may dampen economic growth down the road. For example, during the first round of quantitative easing by the Fed, oil prices soared by more than 50 percent. QE2 also saw food prices rising by around 15 percent and oil prices by another 30 percent. The latest stimulus by Bernanke might just lead to more trouble in the economy down the road.
Written by SiHien Goh