Economic News & Analysis—October 24, 2012

QE-ad infinitum or QE-ad nauseam?

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

The FOMC did not make any significant changes to its policy statement compared with its last statement in September. The FOMC will complete Operation Twist by selling approximately $45 billion a month in short-term Treasury securities and reinvesting in longer-term Treasury securities, and it will continue to buy $40 billion a month in agency mortgage-backed securities. Today’s statement suggests that the FOMC believes exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015. And, finally, the Federal Reserve Bank of Richmond president, Jeffrey Lacker, again dissented from the statement. President Lacker likely believes economic conditions will make it such that this loose policy isn’t going to be appropriate well before the middle of 2015. I tend to agree with Mr. Lacker.

When the FOMC first announced its latest round of quantitative easing (QE), some called it QE-forever or QE-infinity. But, that’s a complete mischaracterization of the U.S. Federal Reserve’s (Fed’s) new policy. The duration of the program is conditional on changes in economic conditions. If the economy was to languish in an eternal state of slow growth and low inflation, then it could be called QE-infinity. However, I think it is highly unlikely that inflation won’t eventually become a problem or that the unemployment rate won’t eventually come down. In that case, it’s simply QE-for now.

Full house

One scenario that could lead to an acceleration in economic activity and perhaps inflation is a rapid increase in household formation. After all, the more households there are, the quicker the housing market will heal. And the quicker the housing market heals, the faster credit and economic conditions can return to normal. Going back to 1990, the number of households has increased by 1.2%, on average. However, from 2008 to 2010, the number of households increased by only 0.4%, on average. From 2010 to 2011, the pace has quickened to 2%, which is likely due to continued economic progress.

In 2010, the fastest-growing household size was those with seven or more persons, which increased by nearly 14%. This is consistent with what happened at the tail-end of the 1991 recession, which was rather mild by comparison. That household size tends to be the most volatile and often results when families combine to lower housing costs. In 2010, there were 1.74 million households with seven or more people. In 2011, that number was 1.738 million. While it’s not a big improvement, it’s headed in the right direction. More rapid job creation will likely make it significantly easier to drive down the number of households with seven or more people.

The Fed has taken on the role of ensuring that interest rates stay low to keep financing costs down for homebuyers. Credit conditions remain tight in the housing market, but those conditions are slowly beginning to ease. Holding back a more rapid recovery is the inability or unwillingness of the Consumer Financial Protection Bureau (CFPB)—set up under the Dodd-Frank Act—to clearly define a qualified mortgage. The definition is important because a bank is afforded some legal protection if it makes a qualified mortgage and that loan goes bad. On the other hand, if a bank makes a nonqualified mortgage, it can open up a legal can of worms. Once the CFPB defines that term, we could see a massive thawing of credit conditions and a more rapid economic recovery. Until then, it’s likely QE-ad nauseam.

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