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QE3 Announcement: What is QE3, and Will the Fed and Bernanke Silver Bullet Work?

The world is once again eagerly awaiting the latest decision by the U.S. Federal Reserve’s Federal Open Market Committee, (FOMC) on whether it will initiate a third round of monetary stimulus since the financial crisis began. 

But going forward over the longer term, there are bigger and more fundamental questions to be answered, notably: Has the Federal Reserve outlived its usefulness, and more importantly, has the Federal Reserve run out of stimulative ammunition?

To answer both, we need to remember what the Federal Reserve was created to accomplish and what tools it was given to pursue this charge.

The Federal Reserve was created by Congress in 1913 "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of re-discounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

The Federal Reserve System is made up of a Board of Governors and twelve regional Federal Reserve Banks located in major cities throughout the country. There are seven members that sit on the Board of Governors. Each member must be nominated by the President of the United States and confirmed by the Senate. Members are appointed to serve 14-year non-renewable terms. The President also nominates members of the board to serve as chair and vice chair for four-year renewable terms. These appointments must also be confirmed by the Senate.

The most important policymaking body of the Federal Reserve System is the Federal Open Market Committee (FOMC). It is composed of the seven governors, the president of the Federal Reserve Bank of New York, and four other reserve bank presidents that serve on a rotating basis. The FOMC can affect monetary policy through the use of three tools:

1. Open market operations — the buying and selling of U.S. government securities.

2. Altering reserve requirements — the amount of funds that commercial banks must hold in reserve against deposits.

3. Adjusting the discount rate — the interest rate charged to commercial banks.

These tools can be used to tighten or expand the money supply. Per the conventional definitions of academic economic thought, if the FOMC wanted to control inflation, it could restrict the nation's money supply by selling government securities and raising the amount of money that member banks need to have on reserve. Both of these actions would take money out of circulation. In theory, a smaller supply of money would lead to less spending, which would lead to lower prices.

The FOMC can also raise interest rates to help control inflation. By making money more expensive to borrow, consumers would be more likely to save money rather than spend it. This could also lead to lower prices. Since America’s battle against inflation during the 1970’s through the 1980’s, the Federal Reserve has focused on inflationary concerns.

Yet inflation appears tame, the nation’s ability to create jobs remains troubling, and the economy is crawling along at a snail’s pace. So what can the Federal Reserve do if anything to enhance economic growth providing the increased demand necessary to fuel additional hiring?

The Fed could expand and lengthen its ongoing “Operation Twist.” Swapping out its short-term bond portfolio for issuances of a longer duration might facilitate the type of long-term capital investment needed to expand demand in the construction sector. Since its October 2011 inception, mortgage rates have fallen too, one factor in real estate prices beginning to stabilize.

The program, which was originally scheduled to end June 30, 2012, is one that would meet with little resistance as it “does not” add to the Fed’s balance sheet. Atlanta Fed President Dennis Lockhart, who previously opposed such an action, has now reversed his position noting, “It’s still one of several options on the table,” he said.

The Fed could take a longer-term approach pushing the discount interest rate lower and targeting those rates to stay in place even beyond their current 2015 bench mark. This policy decision, while lending some “certainty” to the future, is not viewed as likely to have much if any immediate impact on the economy.

Which brings us to the much anticipated announcement on whether the Fed will begin a new round of “Quantitative Easing.” QE3 would likely involve another $400-600 billion expansion of the Federal Reserve’s portfolio, with the purchases occurring over the next six months.

About the only consensus on QE3 is should the Federal Reserve not enact such a buying program, American equity markets which have largely priced this action into stocks values is likely to suffer an immediate decline.

This author agrees with the assessment of former Federal Reserve economist Catherin Mann: “The impact would be microscopic. The Fed continues to want the economy to grow faster and specifically, to grow more jobs, but the ability of QE to do that is extraordinarily limited."

Near record low short/long-term interest rates have not stimulated the economy to expand via capital new investment. Banks are actually sitting on $1.5 trillion in reserves. It has even been contended today’s record low interest rates  are contracting lending making it more difficult for banks to find loans which will allow them to earn even a minimal profit.

There is though hope by some Keynesian economists QE3 could be modestly helpful. They note an expanded money supply could drive stocks higher. They contend lower mortgage rate should continue to stabilize the housing market.

Mortgage rates are indirectly related to the Fed's policies, and in July, they fell to their lowest level on record. That same month, permits to build new homes picked up to their highest level in four years. Home prices have started to rise too.

Now you must decide who is right and who is not concerning has the Federal Reserve outlived its usefulness and does it possess the tools to further stimulate the economy.

The Federal Reserve has accomplished parts of its intended mission such as controlling the money supply, limiting inflation and providing access to capital at historically low levels.

Some will note, the Federal Reserve has failed in its mission by contributing to creation of a “fiat currency” through expansive monetary policy allowing unsustainable levels of national debt to accumulate.

Yet what the Federal Reserve cannot do, nor what it was ever charged to do, was fulfil the role of Congress in establishing the long-term tax/regulatory policies which lend stability and certainty to the economy.

The Federal Reserve has done all it can. Business is not hesitant to invest and hire because interest rates are too high. They are hesitant because Congress refuses to do its job providing certainty for America’s economic future.

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