How big will the Fed’s QE3 end up being?

November 16, 2012

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Polling data courtesy of Chris Reese

We’ll know it when we see it. That’s essentially been the Federal Reserve’s message since it launched an open-ended bond-buying stimulus plan that it says will remain in place for as long “the outlook for the labor market does not improve substantially.” Which begs the question: how much larger is the central bank’s $2.9 trillion balance sheet likely to get?

Minutes from the Federal Reserve’s October meeting point to solid support within the central bank for ongoing monetary easing via asset purchases well into 2013.

A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market.

Still, the report contained some unusually vocal reservations about a continued ramping up of unconventional policies:

Several participants questioned the effectiveness of the current (asset) purchases or whether a continuation of them would be warranted if the recent moderate pace of economic recovery were sustained.  In addition, several participants expressed concerns that sizable asset purchases might eventually have adverse consequences for the functioning of asset markets or that they might complicate the Committee’s ability to remove policy accommodation at the appropriate time and normalize the size and composition of the Federal Reserve’s balance sheet.

One way to gauge the potential scope of QE3 is to take the Fed at its word. The central bank says it will continue to purchase securities until the employment outlook picks up noticeably. While no hard definition has yet emerged for such improvement, policymakers have hinted that the jobless rate, currently at 7.8 percent, might need to come down to at least 7 percent before officials take their foot off the accelerator.

The median of the Fed’s “central tendency” forecasts from individual policymakers suggests they believe the job market will not get there until some time in 2014. Assuming, as many investors do, that the Fed keeps up the current $85 billion pace of monthly bond purchases past the year-end expiration of Operation Twist, and taking the optimistic view that the jobless rate will hit 7 percent at the very start of 2014, that would lead to an additional $1.1 trillion in asset purchases over the next 13 months.

Private sector forecasters seem to take a more sanguine view. Analysts polled by Reuters following October’s surprisingly firm jobs report thought QE3 would max out at around $615 billion. The primary dealer banks that do business directly with the Fed had a different take, however. They thought the program would total $1 trillion. Depending how well the economy can navigate looming risks like the fiscal cliff and Europe’s recession, even that estimate could prove too low.

Recent experience with unconventional policy suggests the quantity of bank reserves is less important than how quickly they are flowing out. So the expansion, while seen as risky by some, appears in line with the Fed’s mandate given a deeply troubled job market and inflation that is forecast to stay at or below target for the foreseeable future.

All of which makes an eventual rate hike seem a rather distant prospect.

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