What Is QE3? Pros and Cons
How It Boldly Went Where No Fed Policy Had Gone Before
First, Fed Chairman Ben Bernanke boldly announced the nation's central bank would maintain expansive monetary policy until certain economic conditions were met. In this case, it was until jobs improved substantially.
The only other time the Fed did anything like this was when it set an informal inflation rate target of 2 percent. It added much-needed certainty, and therefore confidence, to boost the economic engine of growth.
By setting an employment goal, the Fed took a second unprecedented action. It focused more on its mandate to encourage jobs growth, and less on what had previously been its primary emphasis to fight inflation. It was the first time any central bank had specifically tied its actions to job creation.
The third unprecedented move the Fed made was stimulating greater economic expansion, instead of simply avoiding a contraction. This powerful new role meant the Fed was taking on more responsibility for balanced economic health. Monetary policy overshadowed fiscal policy more than ever.
In fact, the Fed was almost forced into this role by elected officials who were not being responsible with fiscal policy.
Instead of focusing on job creation strategies, the two parties were at a bitter stalemate over how to reduce the debt. One party favored tax cuts, while the other wanted to increase spending. They were unwilling to negotiate until the Presidential election was decided.
Fourth, the Fed announced it would keep its target Fed funds rate at zero until 2015.
Chairman Ben Bernanke learned from former Fed Chair Paul Volcker that controlling the public's expectation of Fed action was just as powerful as the central bank's actual behavior. Nothing disturbs the market more than uncertainty. Volcker tamed inflation by reversing the stop-go monetary policy of his predecessors.
In committing to this radical new strategy, Bernanke told elected officials that the Fed was all-in. It had done all it could to support the economy through expansive monetary policy. It was up to legislators to address economic growth through fiscal policy, especially in resolving the fiscal cliff.
What QE3 Did
With QE3, the Fed announced it would buy $40 billion in mortgage-backed securities from member Federal Reserve banks. This took the toxic assets, comprised primarily of subprime mortgages, off the banks' hands. The extra funds allowed the banks to increase lending. This increase in the money supply stimulates demand by giving businesses more money to expand, and shoppers more credit to buy things with.
Combined, these two purchases will add $85 billion of liquidity to the economy.
The Fed's Treasury purchases increased demand for long-term bonds, making yields lower. Since Treasurys are the basis for all long-term interest rates, it makes mortgage rates and housing more affordable.
With QE3, the Fed used its Trading Desk at the New York Federal Reserve Bank to buy $85 billion a month in both MBS and Treasuries from banks. The Fed used its ability to create the credit out of thin air, which had the same effect as printing money. This expansion in the money supply had the added benefit of keeping the value of the dollar low. This boosted U.S. stocks, which are priced in dollars, making them seem cheaper to foreign investors. QE3 ultimately increased U.S. exports, for the same reason.
Another benefit of QE3 was that it allowed continued low-cost expansionary fiscal policy. This boosted economic growth because government spending is an important component of GDP. It also allowed lawmakers to continue spending money without worrying about incurring too much debt and raising interest rates. However, once the debt approached 100 percent of GDP, Congress began calling for reduced spending or higher taxes. The stalemate over which was the better way to reduce the debt led to the debt crisis in 2011 and the fiscal cliff in 2012.
How It Affected You
QE 3 kept interest rates low thanks to high global demand for this safe-haven investment. Most investors consider the U.S. Treasury to be relatively risk-free, since it is backed by the full power of the U.S. government.
By keeping the return on ultra-safe Treasurys low, the Fed hoped to push investors into other areas of the economy, such as higher-yielding corporate bonds. That would boost business growth and the housing market. Low rates convince consumers to save less and shop more, driving much-needed demand.
Many investors were concerned that, by pumping so much money into the economy, the Fed would trigger inflation. They bought gold and other commodities as a hedge. Others bought them because they saq that the Fed's actions would spur global demand for oil and other raw materials. If the Fed saw inflation becoming a big problem, it could easily reverse course and initiate contractionary monetary policy.
Obviously, what's good for consumers and borrowers is not good for savers and those who must rely on a fixed income, whether investors or retirees. Low interest rates mean less income for them.
Another con was that, by going all in, the Fed had nothing else in its arsenal. The stock market responded to the Fed's actions by rising, but once this "sugar fix" is spent, that's it. Investors will be looking for more reassurance, but it won't come from the Fed. And, it won't come from legislators until after the presidential election resolves the direction of fiscal policy.
Last but certainly not least, keeping interest rates low won't solve the nation's No.1 problem, job creation. The reason businesses aren't hiring has very little to do with interest rates. It has everything to do with demand.
History of QE3
QE3 is nothing new. Quantitative easing has long been a tool of the Fed's expansionary monetary policy. Even before the financial crisis of 2008, the Fed held between $700-$800 billion of Treasury notes on its balance sheet. It bought Treasuries to pull the economy out of recession, and sold it to cool things off.
Quantitative easing took off in 2008. It was really needed because the Fed had already done all it could with its other tools. The fed funds rate and the discount rate had both been reduced to zero. The Fed even paid interest on banks' reserve requirements.
The Fed announced QE1 in November 2008. Instead of buying Treasuries, it bought $600 billion in MBS. By June 2010, the holdings had maxed out at $2.1 trillion. The Fed suspended QE1 for a few months until it realized in August that banks were hoarding the cash instead of lending it out. The Fed switched its direction, buying longer-term 2-year to 10-year Treasurys instead of MBS.
In November 2010, the Fed launched QE2. It would buy $600 billion of Treasury securities by March 2011. The Fed wanted to spur inflation, which would lead people to buy more now to avoid higher prices in the future. The Fed officially ended QE2 in June 2011. However, it continued to purchase just enough securities to maintain a $2 trillion balance. .
The Fed effectively ended QE3 in December 2012 by launching QE4. The main change was it ended Operation Twist. Instead of exchanging short-term Treasuries for long-term notes, it kept rolling over the short-term debt. The Fed would continue to buy $85 billion a month in new long-term Treasuries and MBS.
QE4 set new precedents. Bernanke announced the central bank would continue quantitative easing until either unemployment fell below 6.5 percent or inflation rose above 2.5 percent. It would continue to keep interest rates low until 2015. These specific targets encourage economic growth by removing uncertainty. This allows businesses to plan more aggressively thanks to the more stable operating environment.