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Economic News & Analysis—September 13, 2012

FOMC: New guidance and open-ended QE

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

At its meeting today, the FOMC decided to change its forward rate guidance to “mid-2015” from “late 2014.” The committee also announced it would buy $40 billion in mortgage-backed securities (MBS) per month until labor market conditions improve and beyond. This was a double-whammy of monetary accommodation as it not only changed how long the FOMC thinks economic conditions will warrant exceptionally low rates, but it also resulted in a form of “open-ended QE.”

Open-ended QE is simply the Fed expanding its balance sheet but without any precommitment to a certain dollar amount of purchases. The pace and timing of purchases will be determined by economic conditions. Because the Fed is continuing its “Operation Twist,” whereby it sells short-term securities and buys long-term securities, the pace of purchases of MBS and long-term Treasuries will amount to $85 billion per month until the end of the year.

This policy should help keep mortgage rates low to fuel the recovery of the housing market. However, it remains to be seen as to how it can help the rest of the economy. The first round of QE began in November 2008, and the unemployment rate didn’t peak until October 2009. So, either it took an awfully long time for monetary policy to reduce the unemployment rate, or monetary policy simply did little to create jobs.

When the second round of QE was launched in November 2010, it was smaller than the first round, so the effect was expected to be smaller as well. Indeed, the effect on the economy is difficult to discern because most of the easing seemed to just create extra reserves on bank balance sheets instead of actually circulating through the economy. Banks are under pressure to build up their capital buffers, and they are given incentives to hold Treasury securities and keep reserves on deposit with the Fed. Perhaps what’s needed is more “regulatory easing” rather than more “quantitative easing.”

Looking ahead, if nonfarm payrolls don’t begin to increase at a faster pace than 100,000 per month, I’d expect the Fed to speed up the pace of bond purchases. It wouldn’t necessarily do much, but ultimately, there’s not much the Fed can do to create jobs.

If you’d like to see exactly how the FOMC statement changed, visit The Wall Street Journal’s Fed Statement Tracker.

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