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QE: The Fed Goes Big

For the first few months of 2012, one of the primary questions asked about the Federal Reserve was will they or won't they. The question referenced another round of quantitative easing, and the answer finally came in September. That's when U.S. central bank policy makers decided they needed to act again to support the domestic economy by launching QE3, part three in a series of multibillion-dollar bond buys initiated in response to the financial crisis.

Just what is QE3? In short, it's a program that will see the Fed buy up to $40 billion a month of mortgage-backed securities, a type of bond based on mortgage loans, for as long as it sees the need to do so. Many of the nation's homeowners get their mortgages sold by their lenders, packaged with other similar loans and then turned into tradable securities known as MBS. The basic justification behind the Fed creating demand for the mortgage-backed securities is that it should ideally help stabilize the housing market and make it easier for banks and property buyers to do business.

At its latest meeting in December, the Fed moved into the QE4 arena, announcing it will make $45 billion a month in outright Treasury purchases in order to replace the expiring “Operation Twist,” in which the Fed sells short-term government debt and buys long-dated Treasuries, adding zero to the bank' balance sheet.

In a surprise move, the Fed also tied specific unemployment and inflation numbers to their basement-level interest rates, saying there will be no hike until the unemployment rate falls to 6.5% or inflation rises to 2.5%. Currently, the unemployment rate stands at 7.7% and inflation at just under 2%.

A passionate debate about the merits of QE from the pro-and con-easing crowds, including occasionally from within the Fed's own ranks, started long before QE3 became a reality -- and has carried on since. Opponents' primary concerns are that the Fed is enabling bad behavior in the markets and bad habits at the government level with its repeated salves, while also creating an environment that already is or eventually will lead to overpriced assets and the destruction of the dollar's value.

The Fed overall, of course, and Chairman Ben Bernanke would contend otherwise.

Active Involvement

When it announced QE3, the nation's central bank said it was "concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook."

The Fed's initial quantitative easing program in 2008 centered on buying $1 trillion of mortgage bonds, and QE2 was a $600 billion Treasury purchase. All told, with now four QE's and the “Twist,” the Fed has been very active in the bond markets since the financial collapse of four years ago.

In normal times, one of the simplest and most frequently used means of influencing the economy's growth pace is through altering the fed funds target rate. But then, these haven't been normal times for several years. In December 2008, the Fed cut its target rate to 0% to 0.25%. It's been there ever since and should be there for a long time to come, considering the targets the Fed has named.

With the rate-cutting option gone, the bank has taken to the paths described above. Unconventional, yes, but supporters would say the moves are vital to the recovery.

Stocks and Rates Are Lower

There's hardly any disagreement with the idea that the Fed's repeated actions have played a role in the doubling of major equity indexes since the March 2009 lows. Exactly how much of an impact could be discussed extensively, but you aren't likely to find many market participants who would contend it's had absolutely no effect.

However, share prices overall haven't been much to write home about since QE3 got under way. Here are a few metrics from the stock and bond sides:

  • Since QE3 was announced on Sept. 13, the S&P 500 has drifted lower. It closed that day at 1,459.99 and settled at 1,419.45 on Dec. 13, a decline of 2.78%.
  • Treasury yields had pulled back, with the 10-year falling to 1.59% from 1.72%, and the 30-year coming down 16 basis points from 2.93% to 2.77% as of Dec 6. After the latest Fed announcement, the 10-year sits at 1.71% and the 30-year at 2.87%, as of Dec. 14.
  • In the days after round three of QE, the 30-year mortgage rate dropped to 3.49% and the 15-year slipped to under 2.8%. As of mid-December, those rates were even lower, at 3.32% and 2.66%, respectively.

Whether the Fed is ultimately helping or hurting the economy in the long run is going to remain an outstanding issue, and the arguments about what it should do from here won't soon stop.