QE3 Makes History for the Wrong Reasons

Thursday, September 13th marked a historic day in our economic history. The Federal Reserve issued a statement indicating that they will attempt to reduce unemployment by an unlimited purchase program of mortgage backed securities (MBS), aptly dubbed “quantitative easing version three” or “QE3” by market participants. QE3 was historic in the sense that it was unlimited in nature and was directly targeted at reducing unemployment.

The intention of any quantitative easing program is to decrease the cost of credit for the borrower. With the purchase of MBS, the Fed is trying to bring down mortgage rates for the average consumer. The combination of mortgage refinancing and new mortgages at lower rates will leave the consumer with more dollars in their pocket and an increased willingness to spend. Since consumption is consistently hovering at around 70% of U.S. GDP, stimulating this consumption is extremely important to move the recovery forward. This recovery should then lead to more jobs, and the Fed can rest assured that it has done its part in fulfilling the full employment clause of its dual mandate.

The issue with this approach to economic stimulus is that the ordinary transmission mechanism is suffering from overuse. The Fed knows this, which is why they decided not to purchase government bonds. With an assumed lower bound of zero, short term rates can’t be driven much lower by the Fed and the 10-year rate already hit a 60-year low point reaching 1.47% on June 1st. Instead, they purchase mortgages with mortgage spreads — an indication of riskiness — prompting them to fall to 22 hundredths of a percentage over government bonds right after the announcement of the program. The key here is that these lower rates are not being completely transferred to consumers wishing to refinance or take out a new mortgage. There are numerous causes for that beyond the scope of this piece, but I encourage you to read about it here. This was an issue already before QE3, which really begs the question, if Bernanke knew all of this, why would he enact such an ambitious program?

Is it possible that the Fed has a different goal in mind with their new program, knowing that their transmission mechanism isn’t working anymore? Chairman Bernanke’s recent conversation with Reuters gives the impression that the Fed is actually trying to create another asset bubble. The Chairman essentially admits to creating a “risk-on” rally in the market in order to increase the perception of wealth. Chairman Bernanke:

If people feel that their financial situation is better because their 401(k) looks better or for whatever reason — their house is worth more — they’re more willing to go out and spend, and that’s going to provide the demand that firms need in order to be willing to hire and to invest.

In other words, he is fine with creating an asset bubble with potentially disastrous consequences.

The Fed is therefore admitting to opening up the printing presses and indirectly planting some extra dollars in every American’s pocket. This may have some short-term benefits and may indeed decrease unemployment, but at great cost. How can we know the long-term implications of such money printing? How is this any different from the other examples of loose monetary policy leading to excessive inflation and social unrest?

We should all be concerned over the Fed’s recent decision and what it means for the democratic process. An unelected committee of economists is determining the fate of our country, for better or worse. With the fiscal cliff looming and set to shed 4-5% off our current GDP growth rate of 1.5%, the Fed may have decided to preempt a potential government tie-up with an economic booster shot. The implications of an unelected committee of economic central planners coming to the rescue of a dysfunctional Congress should leave us plenty to think about this election.