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FAQ on QE3: Fed policy, inflation and recovery

QE, or quantitative easing, is the controversial monetary policy that has been credited by some for helping us survive the economic meltdown, and blamed by others for running up our debt to unsustainable levels and making damaging inflation a near certainty. It has been stopped and restarted a number of times, been subjected to much debate within both the Fed and in Congress, and is now in its third (some say fourth) iteration. Here is a brief primer on this much debated strategy.

What is QE?

Quantitative easing is a policy of economic stimulus that is implemented when the Federal Reserve buys U.S. Government bonds from its member banks.  This removes the bonds from the bank’s balance sheets, and provides them cash to lend and support the economy.

Did this begin in the financial crisis of 2008?

No, the Fed has always used this strategy (albeit in a much smaller fashion) to make adjustments to the money supply. The policy took on a new dimension in 2007 as the financial crisis loomed, and the traditional tools of the Fed, the discount rate and the Fed funds rate, were at near zero, and no longer effective.

Where does the Fed get money to buy these bonds?

The Fed creates reserve credits in the member bank’s accounts when they purchase the bonds. You’ve heard people say that the Federal government can print money? Well, this is how it’s done.

In what ways does this benefit the economy?

If banks keep reserves of 10% when they lend, each $10 million of credits will enable the bank to make loans of $100 million. This provides money to businesses, consumers and homebuyers, stimulating demand. Also, the increase in money supply tends to keep the dollar lower against other currencies, making our exports more competitive in global markets, and our stock markets more attractive to foreign investors.

How has the policy been implemented since 2008?

QE1, in November 2008, was a direct response to the housing bubble deflating and the ensuing financial collapse. The Fed began purchase of $700 billion of mortgage backed securities (MBS) and other bonds, paused  briefly, and restarted in March 2009 as equity markets fell to new lows, buying an additional $750 billion more in MBS, $100 billion in debt from Fannie May and Freddie Mac, and $300 billion in Treasuries.  It was considered critical to move mortgage-backed securities, many of which had implicit government backing and were now nearly worthless, off the balance sheets of major banks and onto the balance sheet of the Fed, to nurse the banking sector back from near collapse. QE1 ended in June 2010.

What about QE2 and QE3?

While new funds flowed into banks and onto their balance sheets, they remained reluctant or unable to lend.  Credit standards had been tightened, businesses were unwilling to borrow to expand, and consumers had not yet regained confidence. To prevent the economy from losing ground the Fed announced a new round of easing, QE2, between November 2010 and June 2011, buying an additional $700 billion of Treasury notes and bonds.

The third round of quantitative easing, QE3, began in September 2012, as Congress was paralyzed by the coming elections, unable to compromise on taxes or spending, and facing a “fiscal cliff” with uncertain economic implications.  The Fed instituted purchase of another $85 billion of mortgage-backed securities;  for the first time, though, the Fed announced some specific targets to end the QE program of monetary stimulus begun in 2007. In addition to its previously announced 2% inflation target, the Fed made it known it would use an unemployment rate of 6.5% as a benchmark to dial down the easing.

Have events since 2007 changed the role of the Federal Reserve and made it more powerful?

Some would say yes. The traditional role of the Fed since the great Depression has been to prevent uncontrolled inflation, monitor the money supply, and provide a safety net of last resort in an economic  crisis. Chairman Bernanke has certainly accomplished these objectives.  However, by linking the end of QE3 to specific employment goals, the Fed seems to have taken a more proactive role than ever before in promoting economic recovery through employment.

What are the risks now?

Some would say that the damage has been done already, that too much money has flooded the economy and will inevitably lead to inflation, even hyper-inflation.  Should employment and wages begin to accelerate beyond the capacity of the economy to produce goods and services, this could become a reality. On the other hand, if the Fed ends its program too soon, the fragile recovery could stumble, asset prices, especially real estate, could begin to fall again, and layoffs and unemployment could begin to climb. In this scenario, it would be difficult, near impossible to restart another round of stimulus. The Fed is involved in a precarious balancing act with no clear roadmap, and markets remain divided.  Still, we have covered much challenging ground since 2008.  We may soon find out whether the side effects of the medicine that made us better turn the economy in a different and unexpected way.

Steven Weber, Gloria Harris, and Frank Weber are the investment and client services team for The Bedminster Group, providing investment management, estate, and financial planning services. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the authors and do not necessarily reflect those from any other source.

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