What Is QE3? Pros and Cons

How It Boldly Went Where No Fed Policy Had Gone Before

quantitative easing
Fed Chair Ben Bernanke. Photo:Win Mcnamee/Getty

Definition: QE3 is an abbreviation for the third round of quantitative easing begun by the Federal Reserve on September 13, 2012. It was important because it set a new precedent for Fed policy. In it, 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%.

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.

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. (Source: "Three Things the Fed Did Today It's Never Done Before," CNBC, September 13, 2012.)

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.

What Exactly Is QE3?

With QE3, the Fed announced it would buy $40 billion in mortgage-backed securities (MBS) 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.

QE3 also continued Operation Twist, begun in September 2011. This was a program where the Fed sold its short-term Treasury bills and used the funds to buy long-term U.S. Treasury notes

Advantages

How did this help boost the economy? The Fed's Treasury purchases increased demand for long-term bonds, making yields lower. Since Treasuries are the basis for all long-term interest rates, it makes mortgage rates and housing more affordable. (To understand how this works, see Treasury Yields.)

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% 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.

See more Pros and Cons of QE3.

On September 13, the Federal Reserve announced it would extendQuantitative Easing until unemployment is "substantially" better. This unprecedented policy, called QE3,  adds much-needed certainty, and therefore confidence, to boost the economic engine of growth.

The Fed's promise was revolutionary in two more ways:

  1. The policy is tied to jobs, not inflation. This is the first time any central bank has specifically tied its actions to job creation.
  1. The action was not based on fears of future economic contraction, but on a desire to boost a slowly growing economy. (Source: CNBC, Three Things the Fed Did Today It's Never Done Before, September 13, 2012)

What exactly is QE3? The Fed will buy $40 billion in mortgage-backed securities from banks. It will continue Operation Twist, where it exchanges short-term Treasury bills when they become due for long-term 10-year Treasury notes. Combined, these two purchases will add $85 billion of liquidity into the economy. In addition, the Fed will keep the Fed funds rate at current record-low levels until at least 2015.

In committing to this radical new strategy, Chairman Ben Bernanke is basically telling elected officials that the Fed is all-in, and has done all it can do to support the economy through expansive monetary policy. It's up to legislators to address economic growth through fiscal policy, especially in resolving the fiscal cliff.

What It Means to You

First, interest rates will remain 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. The benchmark 10-year Treasury might rise a bit in response to a Fed announcement, it is still below 2%, not far from its 200-year low of 1.44%.

By keeping the return on ultra-safe Treasuries low, the Fed hopes to push investors into other areas of the economy, such as higher-yielding corporate bonds and, yes, even new mortgage-backed securities. This will boost business growth and the housing market. There is indication that this is working. These low rates may also convince consumers to save less and shop more, driving much-needed demand.

Many investors are concerned that, by pumping so much money into the economy, the Fed will trigger inflation. They are buying gold and other commodities as a hedge. Others are buying them because they see that the Fed's actions will spur global demand for oil and other raw materials. However, if the Fed sees inflation as becoming a big problem, it can 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 is that, by going all in, the Fed has nothing else in its arsenal. The stock market has 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 #1 problem, job creation. The reason businesses aren't hiring has very little to do with interest rates. Of course, rate must remain low, that's a given, but business can't move forward with plans until uncertainty about taxes, Obamacare, and the fiscal cliff,  is resolved. That, too, won't happen until after the election.

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. For more, see Current Fed Interest Rates. 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 to 10-year Treasuries instead of MBS. For more, see QE1

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. For more, see QE2.

After QE3

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% or inflation rose above 2.5%. 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.