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Expert FAQ: What the Heck is Quantitative Easing and Will It Help or Hurt My Stock Investing?

Investing

by Susan Lyon

Update: QE3 is now also being referred to as “QE Infinity.”

If you want to sound like a nerd – which we think you very well might – then you must throw the term “QE3” around and we have faith it’ll get you pretty far.  But what does QE3 really mean to you?  Is it us, or does QE3 sound like a sweet video game?

By QE3 we mean Quantitative Easing 3; last Thursday morning the Fed announced a third round of quantitative easing, and the wonky economist blogosphere went wild.  If you read nothing else on this, there are two main things you need to know about QE3:

  • One, the Fed is buying up bonds: lots and lots of mortgage bonds.  It will buy up $40 billion in mortgage-backed securities a month into the indeterminate future, to be precise.  (It buys up debt from investors to encourage them to make more loans, which stimulates the economy.)
  • Two, the Fed has said they’ll keep doing it until the economy significantly recovers.

One of these things is not like the others, friends.  Unlike the first two rounds of quantitative easing – QE1 in 2009 and QE2 in 2010, from which QE3 got its nickname – this week’s QE3 has the particularity of an open-ended bond-buying commitment.  It’s a form of economic stimulus without a defined limit or endpoint.  This signals that they won’t let up until the job is done.

Get what job done?  And why did they have to try it 3 times?

The Fed decided a third round of QE would be necessary for multiple reasons.  Economic indicators were flagging, and though the Bureau of Labor Statistic’s August jobs report released September 7 was encouraging, it wasn’t enough.  Along with the generally sluggish pace of economic recovery, the Fed decided to step in again with this unique form of monetary policy.

What all this means: let the money printing begin and let the interest rates stay low (hovering at near zero, they can’t really go any lower).

The theory behind it is this: buying tons of bonds from commercial banks will force a lot of newly printed money out into the economy, which in turn keeps interest rates low.  This will encourage, in theory, more short and long term investing.

What is the Fed, and Who is Ben Bernanke?

  • The Fed: Short for ‘Federal Reserve,’ the Fed is the central bank of the U.S, established in 1913 to run U.S. monetary policy.  The seven-member Board of Governors runs the Fed, each member of which is appointed by the President and confirmed by the Senate.
  • Ben Bernanke:  Bernanke is the chairman of the Fed, as well as one of the seven members of the Board of Governors.
  • Reserve Banks: There are 12 Federal Reserve Banks that make up the Fed’s network, headquartered regionally across the country in these cities: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco.  They operate under the oversight of the Board of Governors, monitoring and supervising the banks and economic conditions in each of their assigned regions.

The Fed is generally tasked with the dual jobs of keeping both the unemployment rate and inflation rate low, or to promote “maximum employment and price stability” as Bernanke said last week.  They haven’t done so well since the recession with unemployment, but inflation has been below their 2% annual inflation target – so now’s the time to try to shake things up, and with this comes the likelihood that with more printed money pouring into our economy (which is what happens when the Fed buys tons of bonds) then inflation is next to come.

So Will QE3 Work for our Country?  What about for my stock?

Quantitative easing alone is not enough to stimulate our economy and accelerate growth.  There is a rough consensus among experts that it will work better than Q1 or Q2 did, but its impact will still be smaller than what is needed to truly revitalize the U.S. economy.

On the other hand, it provides an important feeling of certainty for potential investors that we will remain on our current low interest rate path for quite awhile.  Certainty is always a positive for doing business, and Bernanke has promised to continue QE3 even once clear signs of economic recovery emerge, signaling stability.  Conversely, printing more money means more inflation and too much inflation can scare away private sector investors necessary for long-run economic growth.

For better or worse, interest rates will stay very low for quite some time.  This is bad news for your “high yield” savings account (they want us to go invest our money instead!) but good news if you have student loans, or if want to buy a house anytime in the near future.

Does this impact stock performance?  That remains to be seen.  Although we cannot speak to any individual stock’s performance, the Dow actually posted a triple-digit gain on the day of the QE3 announcement.  Some believe it will moderately lift stock prices over the next several months as investments yield more, but we would caution that historically inflation has had a net negative impact on stock returns.

Expert Opinions: Was QE3 necessary and was it a good idea?  

The academic experts weigh in on whether this round will be successful, as well as what positive or negative impacts Americans will start to see from it, if any:

  • Professor Karl Case, Professor of Economics Emeritus at Wellesley College, points out the limited power the Fed actually has to change outcomes in light of the current housing crisis and high vacancy rate:

“I don’t think there’s any economist who thinks this round of QE will make a big difference; it’s not likely to have much effect.  That said, I’m agnostic about it.  Since traditional monetary policy was not going to be effective here, the Fed had to come up with a twist on injecting liquidity into the market.  At best it will do some good, and at worst it won’t be dire, though there are some risks – but if inflation picks up too much they can reverse course and raise interest rates again.

Since such a move supposedly reduces the cost of capital at the long end of the bond market, this decision could lead to freer credit underwriting, making it easier for people to get loans.  But it’s hard to nullify the fact that there’s been little housing responsiveness due an extremely high vacancy rate: 18 million unoccupied units and more renters than ever before.  It’s incredible; in the last 7 years we’ve seen 6-7 million new households added in the U.S. but no new owner occupied units.  Rather, the demographics have changed drastically over the last few decades and we’re now seeing more people living alone or together as roommates and renting.  In this climate, there’s not much the Fed can do, though I was surprised to see the bond market rally following the QE3 announcement.”

  • Professor Ethan Kaplan, Assistant Professor of Economics at the University of Maryland, explains why he thinks the Fed’s current monetary policy won’t change much:

“I appreciate what Bernanke is trying to do – but there is not much he can do. He is trying to effect long term borrowing rates by buying longer-term maturity financial instruments.  He is also trying to convince the market that the Fed will be committed to getting to low unemployment even at the expense of inflation – and indefinitely so. As such, he is trying to raise expectations of inflation so that firms aren’t afraid to invest money and hire now. When prices inflation is very low or negative, firms are afraid of spending money now to produce goods that they sell later with lower prices (i.e. at a loss). Bernanke is actively trying to change beliefs about future inflation. However, with short-term interests rates at zero, this is very difficult to do. What would work better would be if the government spent more money on public sector jobs. Since the current Congress is unwilling to act on further stimulus, Bernanke is trying to fill the gap.  At best, he will have a small to moderate impact.”

  • Professor Michael Klein, Professor of International Economic Affairs at the Tufts University Fletcher School, argues that the Fed had to act now, and that it had to get creative to move beyond what hasn’t worked in the past:

“This round of quantitative easing is probably a good thing because our economy is still stalled.  The government has two tools at it disposal to spur economic growth – monetary and fiscal policy – and our government is currently too politically polarized to get any fiscal policy through, for now all we’ve got is monetary.  The Fed can’t do what it would normally do (lower the federal funds rate to lead to other interest rate decreases) because interest rates are already hovering at near zero.  So they’ve had to get innovative and purchase other assets, mortgage-backed securities, to try to impact interest rates at different maturities and longer-term investments: not a typical arrow in the Fed’s quiver.

The real hope is that the increases in home buying and refinancing that will occur as a result will put extra money in people’s pockets month to month, which they will then spend – thereby spurring the economy into action and creating a virtuous circle.  The other hope is that the Fed’s announcement will increase general consumer confidence in the recovering economy.  To be sure this is relatively unchartered territory for the Fed, but the alternative, doing nothing, would have been unacceptable.”