The Federal Reserve is looking increasingly desperate as it layers one monetary stimulus program on top of another, but no one can fault Chairman Ben Bernanke and company for being timid.
Going into its Sept. 12-13 meeting, the Fed's policymaking Federal Open Market Committee (FOMC) already had renewed its Maturity Extension Program or "Operation Twist," and the New York Federal Reserve Bank was in the process of buying $267 billion in longer-term Treasury securities through year's end.
Now, the FOMC announced Thursday, the Fed also will buy $40 billion per month of agency mortgage-backed securities (MBS) in a third round of quantitative easing (QE3) — until further notice.
Unlike Operation Twist, whose bond purchases are financed by sales of shorter-term securities in the Fed's portfolio, this third round of large-scaled asset purchases will create new reserves and further expand the Fed's already bloated $2.8 trillion balance sheet. And that's not all. The two-fisted FOMC also is having another go at verbal easing.
The FOMC further delayed the expected date of initial short-term rate hikes until at least mid-2015. Since January it had been saying it expected the Federal Funds rate to stay near zero "at least through late-2014." Prior to that, dating back to August 2011, the FOMC was putting the funds rate "lift-off" date at "at least through mid-2013."
Just as important as the actions themselves are the FOMC's new strategy and new way of communicating. There were two important new approaches.
First l, the FOMC made QE3 open-ended. In contrast to QE1 and QE2, in which large amounts of total intended bond purchases were preannounced over a predetermined time period, QE3 has no fixed amount or end date.
The Fed will continue to buy $40 billion of MBS per month indefinitely. "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," the FOMC statement said.
This will give the Fed additional flexibility. As Bernanke said in his post-FOMC news conference, how much bond buying the Fed does will be "a function of how the economy evolves," he said. "If the economy is weaker, we'll do more. And in those cases probably rates would be pretty low in any case because the economy is looking weak."
He also made clear that the FOMC could adjust the composition, not just the size of its asset purchases from meeting to meeting.
The FOMC also augmented its "forward guidance" on the path of the funds rate in important ways, presumably to meet objections that its conditional pledge to hold rates low was not sufficiently credible. Beyond merely extending the anticipated zero rate period from "late-2014" to "mid-2015," the FOMC removed the conditionality it had been attaching to the calendar date.
Gone was the old caveat that "economic conditions — including low rates of resource utilization and a subdued outlook for inflation over the medium run — are likely to warrant exceptionally low levels for the federal funds rate...." Now the FOMC is stating bluntly that it expects to keep the funds rate near zero "at least through mid-2015."
What's more, the FOMC said it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."
In case there were any doubts about the Fed's intentions, Bernanke told reporters the FOMC has an "obligation" to continue using its various policy tools until it sees "substantial" labor market improvement. “We will be looking for the sort of broad based growth in jobs and economic activity to signal sustained improvement in labor market conditions and sustaining employment," he said, maintaining that low inflation allows the Fed to do that.
Even if inflation rises above the 2% target, the FOMC will not necessarily desist, he implied. In that event, the FOMC will "take a balanced approach," he said. "We bring inflation back to the target over time, but we do it in the way that takes into account the deviations from both of their targets."
Why did the FOMC take these dramatic steps?
Well, the FOMC explained its action by saying it was "concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions."
Many will point to the dismal August employment report, with its meager 96,000 non-farm payroll rise; 41,000 downward revision to prior months and 368,000 plunge in labor force participation, or to Bernanke's Aug. 31 speech in Jackson Hole, where he expressed "grave concern" about "the stagnation of the labor market" and vowed to "provide additional policy accommodation as needed."
But the Sept. 13 decision was not a result of one month's jobs data, ugly as they were. Nor did it happen because Bernanke had a sudden epiphany in the shadows of the Grand Tetons. It was the culmination of a series of disappointments going back months.
Remember that, as the year started, the labor market seemed to be on the mend. From December through February, payrolls rose an average 245,000 per month. But Bernanke was skeptical, warning in March that "further significant improvements ... will likely require a more-rapid expansion of production and demand..."
His Okun's Law-based fears that the economy wasn't growing fast enough to reduce unemployment soon were realized. In March, payroll gains dipped to 143,000 and then decelerated even more sharply — to 68,000 in April, 87,000 in May and 45,000 in June.
The July employment report, released a couple of days after the FOMC decided on Aug. 1 to stay on hold and take "more time" to assess the impact of the renewed "Operation Twist" bond-buying program, was seen as encouraging by officials who were uncertain about whether more easing was needed when it showed non-farm payrolls rebounding by 163,000. But less than a week before the FOMC convened in September, that number was revised down to 141,000, and the 96,000 August rise suggested a return to the dreary pre-July pattern.
And the FOMC was convinced that the outlook wouldn't be much better unless it did more to cushion the economy against downside risks from the fiscal cliff and Europe. As they performed their quarterly ritual of revising their three-year economic projections and federal funds rate forecasts, Federal Reserve Bank Presidents and Fed governors did not see much improvement on the horizon.
Still, why did the FOMC go ahead with new easing measures at this politically sensitive time?Why — when a vocal cadre of officials have been warning that the Fed has done all it can effectively do in the face of non-monetary impediments and that the cost of further easing would exceed the benefits? Why do QE3 when the Fed already had one stimulus program — Operation Twist — running? Why delay rate hikes when officials and academics alike have questioned the credibility and efficacy of such pledges?
There are two basic answers:
1. The FOMC majority believes that its statutory dual mandate commands the Fed to use the tools at its disposal even though internal and external factors may limit their impact. If there are forces such as mortgage lending constraints and business and household uncertainty about taxes, regulation and health care costs that are gumming up the "monetary transmission mechanism," well then, the Fed just needs to push all the harder on its policy levers.
An ancillary point is that the FOMC majority believes the economy's woes are primarily "cyclical," which is to say because of a shortfall of aggregate demand, and thus amenable to monetary policy.
2. If the normal interest rate channel through which lower rates are supposed to work is clogged, that doesn't render monetary policy impotent in the eyes of the FOMC majority. There are other channels through which unconventional easing measures can work that policymakers would rather not talk about publicly — namely the exchange rate channel. Lower rates and rate expectations should, in theory lower the value of the dollar, making U.S. goods more competitive in global markets and boost net exports.
The Fed also hopes that by holding rates very low, investors will put their money into riskier assets such as stocks, yielding a positive "wealth effect" on the economy.
Well, what's next?
The Fed, in its limited experience with QE has never done an "open-ended" asset purchase program. QE1 and QE2 involved pre-announced and well-defined large amounts of bond buying with a fixed end date. QE3, as designed, seems like a sensible departure and likely garnered support it might not otherwise have had because of its flexibility.
For one thing, it parallels more conventional monetary policymaking in which, in normal times, the FOMC decides meeting by meeting how much to adjust the federal funds rate. It will enable the FOMC to honestly say it is not wedded to a predetermined amount of easing and can terminate the bond buying, or extent and enlarge it, depending on the circumstances.
How much or how little the FOMC ultimately will decide to do is anyone's guess. It will depend, among other things, on the election’s outcome, the steepness of the fiscal cliff, the success of the European Central Bank's latest bond-buying adventure and the magnitude of the Chinese slowdown.
One thing is for sure, until such time as the composition and/or leadership of the FOMC changes significantly and so long as it has tools left to use, the Fed will keep plugging away at stimulating the economy.