FOMC Announces QE3

The Federal Open Market Committee (FOMC) concluded its two-day September meeting and released its statement.  The big news is that the Fed is planning another round of quantitative easing (money creation out of thin air).  This is the third round of it since 2008 and is therefore referred to as QE3, although not in the FOMC statement.

The statement contains the usual fluff, so there is no need to go over the entire thing.  I'll just cover the major parts.

The FOMC stated, "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities."

In other words, the Federal Reserve will roll over expiring debt, but into longer-term securities.  This is a continuation of Operation Twist.

The new base money being added is the $40 billion per month.  In other words, we should see the adjusted monetary base increase by approximately $40 billion each month.

The FOMC statement continued, "The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."

So QE3 is essentially open ended.  But they added the caveat that it is "in a context of price stability."  In other words, the Fed will keep buying debt to help unemployment and it won't stop until either there is an improvement in unemployment and the economy or if price inflation becomes a problem.

The FOMC statement also said that the federal funds rate will remain low until at least mid-2015.  That means the rate will be near zero for almost 7 years if they stick to that.

The most interesting part of the whole statement, aside from the announcement of QE3 itself, is how they are implementing it.  They are buying mortgage-backed securities (MBS) as opposed to the more typical buying of regular government debt.  But why would this help the economy?  The explanation doesn't make any sense.  Mortgage rates are already at or near all-time lows.  If a 30-year fixed rate mortgage drops from 3.5% to 3.0%, is that really going to turn the economy around?

Ironically, immediately after the statement was released, the stock market went up, gold went up, and the 10-year yield went up.  The 10-year interest rate is highly correlated to mortgage rates.  So the Fed's announcement actually sent rates up for a brief time, in opposition to what it is supposed to achieve.  The rate did come back down before the day was over, but bonds did not boom on the announcement the way that stocks and commodities did.

My big question is if the Fed's buying of MBS will be like it did back almost 4 years ago.  Will the Fed pay the current market value for the securities?  Or will the Fed pay the old value for the MBS?  If it is the latter, then we know why the Fed is doing this whole thing.  It is another bailout of the major banks.  Perhaps the Fed knows something about the banks.  Perhaps it is afraid of the big banks being insolvent and is secretly bailing them out with this announcement.  If anyone knows with any certainty the answer to whether or not the Fed intends to pay the current market value for MBS, please drop a comment.

To put this whole thing in context, QE2 was about $600 billion over 8 months.  If the Fed does QE3 for one year, that will be $480 billion.  But this is still a huge number.  It is over 50% of what the Fed's assets were back about 4 years ago.  I really believe that this could finally be the start of bigger price inflation.  There is a cost to this destructive policy and price inflation will be one of the costs.