|The Federal Reserve Building, DC.|
|Ben Bernanke from an Article in The Atlantic Magazine|
The third round of quantitative easing, or QE3, which was announced by Fed Chairman Bernanke a couple of weeks ago, was completely different, not because of what the Fed would do, but because of how it would do it. This time the Fed is going to buy $40 billion of mortgage-backed securities (MBS) per month, until the US labor market improves. Bernanke said essentially that this program would be open ended, and would continue until the economy is well on it's way to recovery. Now what does this mean exactly? Well, for a start, the Fed is committing itself to buying securitized US mortgages, which as any undergrad student of economics knows will increase the demand for this type of bond, and so will increase price, which will reduce yield. The immediate effect then of doing this will be to keep mortgage rates very low, as banks will be able to issue up to $40 billion of new mortgages per month without putting any upward pressure on mortgage interest rates. This in turn, will be a big stimulus to the housing market, one of the key sectors in the US economy. All well and good so far.
The main problem with the policy though is that the so-called "transmission mechanism" for this form of unconventional monetary policy is not entirely clear, and here's why. Given that this stimulates mortgage lending (as banks know that they can easily package up the mortgages and sell them on as MBS), this will clearly stimulate both existing and new housing activity, which will mean more housing construction. So that will, in turn, mean more construction workers will be hired, which should increase employment, and that in turn will boost payroll numbers and bring down unemployment. But employment in construction, even at the height of the housing boom in 2006 only represented about 8% of total US employment, so that is not really going to have a huge impact on the labor market, plus, many of the hires that do occur for manual construction jobs tend to be illegal or undocumented workers, so this won't feed into the official statistics either.
Of course I cannot imagine what the Fed economists have in mind for the transmission mechanism for QE3, but the only thing I can think of is that a mini-housing boom causes house prices to rise, and that in turn gives rise to so-called "wealth effects". These wealth effects result from people feeling better off because they have a net profit in their property, so go out and and spend as they did back in the 2000s. There are also likely to be wealth effects arising from the stockmarket as well, as obviously market sentiment has improved in the knowledge that the Fed has backstopped the economy for the moment, and so share prices should continue to firm. But the danger here is that these mechanisms are very - how might I put it - inexact. Obviously imprecision is not an excuse for inaction, but on the other hand it really is sending the Fed into uncharted territory.
Now please don't get me wrong here - I'd rather the Fed did something rather than nothing, as we clearly need more stimulus from somewhere, but I'm just a little uncertain as to how well QE3 will work. I guess only time will tell.