QE3 arrives

By Felix Salmon
September 13, 2012

It’s basically the same thing that we’re used to at this point, but it’s got enough in the way of new bells and whistles to get people excited anyway — and boost economic growth. So, it’s a good thing, even if it’s not in any way revolutionary.

I’m talking about QE3, of course, although I could equally well be talking about the iPhone 5. You’ve heard more than enough already about the iPhone’s larger screen and new connector and so on and so forth, so let’s talk about monetary policy instead.

The main news isn’t the fact that the Fed is back in the market, buying bonds. Indeed, as Binyamin Appelbaum points out, QE3 in volume terms, at $40 billion per month, is significantly smaller than QE1 and QE2.

The innovation comes rather in the messaging. For instance, we haven’t seen anything like this before:

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.

What this means is that QE3, unlike QE1 and QE2, has no set expiry date. The Fed’s not trying to kick-start the economy any more: instead, it’s promising a steady extra flow of monetary fuel for the foreseeable future — or at least until the labor market improves “substantially”. Which is likely to be a pretty long time.

That would be a big enough deal on its own, but the Fed went even further in the following paragraph, where they all but promised zero interest rates until mid-2015:

The Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

The job of monetary policy, in the famous words of Fed chairman William McChesney Martin, is “to take away the punch bowl just as the party gets going”. The Fed, here, is essentially disowning Martin, and saying that they’ll keep refilling that punch bowl with high-grade hooch even after the party is getting going.

Of course, there’s wiggle room here, but the Fed has invested a lot in its own credibility, so it’s fair to believe that it’s going to do what it says it’s going to do.

And so while the headlines are all about QE3, the real innovation here is that the Fed is moving aggressively into the world of words rather than deeds. Buying bonds isn’t enough any more: the Fed is now trying to boost the economy by promising to continue buying bonds, in a zero-interest-rate environment, for many, many quarters to come. It’s the promise, rather than the purchases themselves, which is the main difference between QE3 and its predecessors.

In his Jackson Hole speech, Ben Bernanke had a whole section on “Communication Tools”, talking about the “use of forward guidance as a policy tool”, and saying that it has been pretty effective up until now. Today’s announcement is a huge bet on those tools, basically using them to a degree unprecedented in recent history.

The Fed is also specifically targeting mortgage bonds in particular, on the grounds that lower mortgage-bond yields will feed through into lower mortgage rates, which in turn will feed through into healthier housing prices. That’s a stretch: mortgage rates have not been falling in line with mortgage-bond yields, and in any case the relationship between mortgage rates and house prices is tenuous at best. But the Fed has to buy something, if it’s going to do QE operations, so mortgage bonds it is.

None of this is going to make any noticeable difference before the presidential election: it’s all marginal, really. But if it seems as though QE3 is having a bit more of a real-world effect than QE2 did — if, that is, it helps the job numbers rather than just the markets — then the lesson will be clear. The Fed’s balance sheet is a powerful tool to use — but its vocal chords might be even more powerful still.

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