On September 13, the Federal Reserve announced it would extend Quantitative Easing until unemployment is "substantially" better. This unprecedented policy, called QE3, adds much-needed certainty, and therefore confidence, to boost the economic engine of growth.
The Fed's promise was revolutionary in two more ways:
- The policy is tied to jobs, not inflation. This is the first time any central bank has specifically tied its actions to job creation.
- The action was not based on fears of future economic contraction, but on a desire to boost a slowly growing economy. (Source: CNBC, Three Things the Fed Did Today It's Never Done Before, September 13, 2012)
What exactly is QE3? The Fed will buy $40 billion in mortgage-backed securities from banks. It will continue Operation Twist, where it exchanges short-term Treasury bills when they become due for long-term 10-year Treasury notes. Combined, these two purchases will add $85 billion of liquidity into the economy. In addition, the Fed will keep the Fed funds rate at current record-low levels until at least 2015.
In committing to this radical new strategy, Chairman Ben Bernanke is basically telling elected officials that the Fed is all-in, and has done all it can do to support the economy through expansive monetary policy. It's up to legislators to address economic growth through fiscal policy, especially in resolving the fiscal cliff.
What It Means to You
First, interest rates will remain low thanks to high global demand for this safe-haven investment. Most investors consider the U.S. Treasury to be relatively risk-free, since it is backed by the full power of the U.S. government. Although the benchmark 10-year Treasury rose a bit in response to the Fed's announcement, it is still below 2%, not far from its 200-year low of 1.44%.
By keeping the return on ultra-safe Treasuries low, the Fed hopes to push investors into other areas of the economy, such as higher-yielding corporate bonds and, yes, even new mortgage-backed securities. This will boost business growth and the housing market. There is indication that this is working -- see Why Banks Are Lending Again. These low rates may also convince consumers to save less and shop more, driving much-needed demand.
Many investors are concerned that, by pumping so much money into the economy, the Fed will trigger inflation. They are buying gold and other commodities as a hedge. Others are buying them because they see that the Fed's actions will spur global demand for oil and other raw materials. However, if the Fed sees inflation as becoming a big problem, it can easily reverse course and initiate contractionary monetary policy.
Obviously, what's good for consumers and borrowers is not good for savers and those who must rely on a fixed income, whether investors or retirees. Low interest rates mean less income for them.
Another con is that, by going all in, the Fed has nothing else in its arsenal. The stock market has responded to the Fed's actions by rising, but once this "sugar fix" is spent, that's it. Investors will be looking for more reassurance, but it won't come from the Fed. And, it won't come from legislators until after the Presidential election resolves the direction of fiscal policy.
Last but certainly not least, keeping interest rates low won't solve the nation's #1 problem, job creation. The reason businesses aren't hiring has very little to do with interest rates. Of course, rate must remain low, that's a given, but business can't move forward with plans until uncertainty about taxes, Obamacare, and the fiscal cliff, is resolved. That, too, won't happen until after the election.