Fed agrees on QE3 with less optimism

On Thursday the FOMC agreed to additional asset purchasing to provide a boost to the economy, citing under-performing conditions. It was clear that the US economy did not experience significant growth after Bernanke's Jackson Hole speech and the Fed Minutes last month. The Fed needed to see substantial growth in employment and productivity, but the opportunity to act was very clear after disappointing jobs numbers and a manufacturing slump. The worry now is that the economy might not reach a substantial recovery, even with further guidance to 2015 given its current pace of growth and fiscal woes that remain unsolved. If this continues, the Fed's exit strategy will be very difficult, and will leave the economy dependent on monetary stimulus instead of sustainable policies that gradually correct structural issues.

QE3, the Fed's third round of quantitative easing, has three components

1. Additional asset purchasing of agency MBS at $40 billion per month. 
2. Extending the average maturities of holdings and reinvesting principal payments. 
3. Extending guidance through 2015 for a potential rate hike out of near zero levels (indicating a possible point of economic recovery).

Note that the second component is the extension of Operation Twist. 

The hope is that "downward pressure on longer term interest rates [might] support mortgage rates, and help make broader financial conditions more accommodative." Bernanke stressed during his press conference that the easing measures will encourage greater investment and employment. It's all about jobs. However, we didn't get a strong sense of optimism or even confidence from the Fed. Bernanke's sharp tone and aura of disappointment was evident. Forward looking statements by Bernanke and the FOMC justify this observance. 

The Fed stated that if the labor market does not improve "substantially," the FOMC will continue and/or purchase more mortgage-backed securities (MBS). The amount of further purchases remains unclear, as the Fed will conduct a cost/benefit analysis if appropriate in order to determine the scale of further operations. The chance of the economy recovering substantially are very thin. The Fed is exhausted with easing, which seems to go nowhere amidst political dithering. The effects of QE are difficult to quantify as reports merely state that employment could be worse without it. The fact that employment remains sluggish even with additional stimulus sparks some concern.

Furthermore, the FOMC board forecast in its latest summary of economic projections estimate real GDP to slow as the year ends. The Fed doesn't see any significant improvements until mid-2013, with a full recovery hopefully around 2015. The FOMC estimates that the unemployment rate will drop to 7.6% - 7.9% in 2013, and then 6.7% - 7.3% in 2014. 

A pledge for a "highly accommodative stance of monetary policy" remaining appropriate even after the economic recovery strengthens is worrying. Continued doses of QE keeps the economy dependent on monetary support. There needs to be a balance between monetary and fiscal stimulus. The exit strategy needs to be executed cautiously to avoid returning to the same problem or worse. The fiscal cliff will be the first test of political strength, but a well thought out plan to boost productivity is in desperate need. 

The markets responded as expected to QE3. The US dollar declined across the board as equities rallied to new highs. However, treasuries sold off in disappointment following an earlier auction on the long end. The Fed essentially left treasuries in the dust, placing favor in MBS for this round of QE. That missed demand on the long end was quite a damper to treasury investors. MBS operations are highly complex, but the Fed's FAQ section from 2010 serves as a good guide to understanding the basics. 

Gold and Silver rallied as market sentiment turned risk-on.

*Canada update in the next post!