Friday, September 14, 2012

The Fed's QE3: An Old Dog Pulling An Old Trick

Since the financial crisis of 2008, the Federal Reserve has striven to show that an old dog can learn new tricks. Its grab bag of novel programs have at various times propped a variety of financial markets, ranging from commercial paper to asset backed securities to U.S. Treasury securities, as well as banks and other financial institutions. Its aggressive use of quantitative easing has in particular stood out from Fed monetary policy of yore, in which discount and fed funds rate adjustments, along with changes in bank reserve requirements, were the only flavors of monetary policy served up.

The recently announced QE3 looks innovative: it's permanent until the labor market is doing 70 in a 35mph zone, will involve $40 billion of purchases per month, and is focused on mortgage backed securities. The Treasury securities market isn't targeted (although it's still being stage managed through Operation Twist to push down yields on long maturities). But QE3 is really just an old trick performed in a different way.

Going back to the new paradigm days of Chairman Alan Greenspan, the Fed has believed that the real estate market leads recoveries. One of the Fed's major frustrations with the Great Recession has been the moribund housing market. It remains badly hung over from over-indulgence in leverage, and battered consumer balance sheets make it difficult for many wannabe buyers to qualify for loans. QE3 is a direct shot of liquidity into the housing market, made with the hope of lowering mortgage rates, stimulating buyers and boosting the economy.

But we've heard this song before. After the 2000 tech stock crash and the 9/11/01 stock market swoon, Chairman Greenspan squashed interest rates with the intention of goosing real estate in order to keep the economy growing. It worked. Already in recovery mode from a downturn in the 1990s, real estate skyrocketed in the early and mid-2000s. The economy grew. Employment levels were good. Everything was peachy.

Until the bubble burst. Since 2007, we have paid the price for the Fed's campaign ten years ago to use the housing market as a way to foster economic growth. Too much of America's wealth was invested in real estate, and the resulting losses continue to choke the economy. One would think the Fed learned a lesson--that concentrating America's capital into a single market sector is risky and when that market sector turns down (as all markets do from time to time), the losses are exacerbated by the over-concentration.

But perhaps old dogs fall back on old tricks. There is serious concern that the Fed has run low on ammo. It can't push interest rates much lower. It can't keep distorting the U.S. Treasury market and give the federal government a very low cost way to run up the deficit. And banks don't want to lend no matter what the Fed signals, because loans are risky and the banks could take losses. So the Fed has decided to directly finance the mortgage markets by purchasing $40 billion per month in the MBS market. In other words, it's going to goose the housing market in the hope of stimulating the economy.

Some people like roller coasters. Others find them nauseating. The last time we got on this roller coaster, the ride ended badly. Nevertheless, the Fed is getting on again. Short term, it may enjoy success, just as the Greenspan Fed enjoyed success--for a while. But long term, the Fed faces a dilemma. In order to prevent another real estate bubble, the Fed has to maintain prudent lending standards. But prudence won't lead to the euphoric exuberance that could launch the economy into the dramatic rise that the Fed seems to be seeking. Will the Fed use its supervisory powers over the financial system to loosen up lending standards, with the concomitant risk of a housing bubble and bust, followed by a Greater Recession? Aroma of rat drifts into the ambient environment. QE3 may not really work unless it fosters really large risks. And we know what can happen when there's a lot of risk around.

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