On September 13, Federal Reserve Chairman Ben Bernanke announced that the Fed would undertake a new program “QE3” to stimulate the U.S. economy. But what, exactly, is it, and how is QE3 likely to affect you and the rest of us?
“QE,” stands for “quantitative easing,” a term which refers to a simple tool that any government’s central bank can use to put new money into its economy. In most cases, the central bank buys government bonds and puts them on its balance sheet. QE1 was the Federal Reserve Board’s response to the 2008 global economic meltdown when it purchased $600 billion of toxic mortgage-backed securities (pools of home loans) of large lending institutions. QE2 started in November of 2010, when the Fed purchased another $600 billion of Treasury securities.
So what is QE3? In its third round of stimulus, the Fed has pledged to buy $40 billion worth of mortgage-backed securities a month. If QE3 works as expected, the additional money will drive down mortgage rates, make homes more affordable, attract new buyers of homes and stimulate the construction industry. At the same time, QE3 will put a little extra money in the pockets of people who refinance their current mortgages at lower rates. If they spend some of that money, then that, too, will help spur additional economic activity.
How is it working so far? Interestingly, mortgage rates have hardly budged because banks haven’t relaxed their tight lending standards. Many banks currently have so many refinancing applications on their desks that they can’t process any more. As a result, instead of lending more money at lower rates, banks are simply taking a larger spread on the loans they do make.
The biggest impact, so far, has been on stock prices. As the Fed buys mortgage pools, QE3 is driving down the returns that investors can get on Ginnie Mae and Fannie Mae mortgage-backed bonds, the most attractive fixed-income vehicles in a marketplace. As those investments deliver lower yields, stocks, especially those of dividend-paying companies, become relatively more attractive.
The last and perhaps most effective stimulative effect is psychological. Unlike the QEs of the past, the Fed has put no time or dollar limits on QE3. The program will continue until the Fed has decided that there is “substantial improvement” in economic growth and the unemployment rate. In real terms, it appears that the Fed has lost patience with corporations hoarding cash rather than investing in their own (and the economy’s) growth, and banks that have been sitting on all the cheap QE money that is available to borrow and re-lend at a profit to homeowners and corporate borrowers. If these companies stay on the sidelines and refuse to participate in the economic growth that the Fed is determined to engineer, then they’ll be left behind and forced to answer to their shareholders.
How much growth are we talking about? Estimates vary, but the U.S. economy needs to reach 3% annual GDP growth before hiring levels absorb new job market applicants and start to reabsorb the people who lost their jobs in the downturn. The Fed seems to have decided that reviving the construction industry is the most focused possible way to bring about the growth that economists would expect America to achieve by 2014 without the benefit of a stimulus.