Is QE3 working? What the markets are telling us about the Fed’s move.
By Neil Irwin,
The Federal Reserve’s decision Sept. 13 to intervene in markets on an unlimited scale until the economy gets on track has drawn plenty of debate and analysis. But what do we know now about whether it is working?
The ultimate goal of the “QE3” policy, as the third round of “quantitative easing” has become widely known, is to bring joblessness down to more reasonable levels without allowing inflation to get out of control. Only with time will we know whether Fed Chairman Ben S. Bernanke and the Fed’s policy committee have threaded that needle correctly.
But the new Fed policy tools work through some very specific mechanisms, many of which can be measured by what is happening in financial markets. In that sense, we can get some early returns on how QE3 is affecting the economy, for good or ill. I’ll give each one a letter grade, depending on how well that measure is fulfilling the Fed’s goals so far.
Mortgage rates: C+
One of the key benefits from the easing policy is to push down interest rates for mortgages and other long-term loans, such as certain corporate investments. The policy includes buying $40 billion of mortgage-backed securities, issued by the likes of Fannie Mae and Freddie Mac, each month. That means the Fed is funneling newly created money directly toward home loans to try to make it cheaper for Americans to buy or refinance a house.
There seems to be a hitch in the system, though. The week before the Fed’s policy meeting July 31 and Aug. 1, when the committee first hinted directly that QE3 was coming, 30-year fixed-rate mortgages averaged 3.49 percent, according to Freddie Mac. The first full week after the announcement — the week that ended Sept. 20 — the number was exactly the same. Rates dipped a bit more, down from 3.55 percent, from the week before QE3 (ended Sept. 6) to the week after, but this was a situation in which markets gradually priced in the policy over a period of months.
What seems to be happening is that banks are cutting the mortgage rates they charge customers only gradually; if the banks slashed rates too fast, they would be overwhelmed by the demand from Americans looking to refinance or buy a home and would not be able to handle the load. Keeping rates high increases banks’ profits and allows them to winnow demand to a manageable number of applicants.
That may be bad news for potential home buyers and refinancers right now. But it comes with a silver lining: It implies that rates should come down over the months ahead as banks work through their backlogs.
Inflation expectations: A-
Investors are expecting inflation to rise. And that may be a good thing.
Bond market indicators are pointing to significantly higher inflation in the coming years than they did this summer, which seems to be a direct reflection of QE3. The difference between rates on ordinary five-year bonds and those indexed to inflation, a measure of how high investors expect inflation to increase, was 2.17 percent Monday morning, down from a recent high of 2.37 percent just after the policy move but well above its level of 1.68 percent before that July-August policy meeting.
On the one hand, the 2.17 percent inflation forecast over the coming half-decade is only a bit above the 2 percent that the Fed officially targets. But it is within a comfortable range for Fed leaders and is actually closer to the target than the July level.
More broadly, slightly boosting inflation expectations is among the ways that the Fed hopes its QE policy will work. In effect, higher inflation means consumers and businesses are experiencing lower “real” or inflation-adjusted interest rates, giving them greater incentive to buy a house or build a factory now. If a dollar tomorrow will be worth less than it is today, that creates more incentive to spend that dollar today.
On the other hand, if inflation expectations get really out of control, far beyond the Fed’s target, it could destabilize the economy and sap confidence. One slightly worrisome sign: Today’s “break-even” rates, which measure inflation expectations, rose even more for a 30-year time horizon, to 2.47 percent from 2.15 percent before the last Fed meeting. Fed officials are surely keeping an eye on those numbers, hoping that their aim for a small rise in inflation in the short run doesn’t do lasting damage to their longer-term credibility as inflation fighters.
One of the great worries within the Fed and in the global community is that QE3 will spark a jump in the price of commodities as the new money being pushed into the financial system bids up prices for oil, food products and metals. Such a result could ultimately hurt the U.S. economy, with higher gasoline prices possibly counteracting the positive benefits of lower interest rates.
The worst fears of those QE3 skeptics have not come true so far. Crude oil prices are down since the Fed action, at $91.79 for a barrel of light sweet crude one month out on the New York Mercantile Exchange, down from $98.31 the day of the QE3 announcement. Oil prices are up over the months it took QE3 to go from possibility to concrete action, but only slightly, rising from $88.06.
Corn prices made a giant leap in June and early July, but that was because of the drought in middle America; corn price futures are down a bit since the QE3 decision and over the longer horizon of its buildup. Copper and other metals present more worrying signs, having risen significantly since July.
Overall, though, horror stories about the Fed’s policies unleashing steeply higher prices for food and fuel aren’t supported by the facts.
The dollar: B
One of the ways Fed actions can help the economy is by reducing the value of the dollar relative to other currencies. This makes U.S. exporters more competitive on the international marketplace, though at the cost of paying more for imports.
Here, the Fed policy would seem to be a smashing success, though with an important asterisk. The dollar index, which plots the value of the dollar against six other major currencies, has fallen 3.6 percent since July 31, dropping as expectations grew that the Fed would enact QE3.
But a lot else was going on internationally. Most important, the European Central Bank and other euro-zone authorities took a series of bolder steps to ensure that the euro, the world’s second-most important currency, would remain viable. That pushed the value of the euro from $1.23 at the end of July to $1.29 on Monday, and the flip side of a higher euro is a lower dollar.
So, currency markets are moving in ways that benefit U.S. exporters — but the Fed action isn’t the only, or necessarily the primary, trigger.
The stock market: Incomplete
Critics have argued that the Fed’s easing policies merely goose the stock market, creating paper gains for large investors without benefiting the broader swath of Americans. But in this episode, it’s not even clear how successful the Fed has been at boosting asset prices.
The Standard & Poor’s 500-stock index is up 5.8 percent since July 31, and it took an extra leap in the days after the QE3 announcement. But some meaningful part of this rally is tied to a sense of resolution of the European crisis. The German stock market is up 9.3 percent in the same period.
So, while it’s clearly true that quantitative easing can boost the stock market and thus increase Americans’ wealth, it is too soon to determine how much of the summer stock rally can be laid at the feet of Bernanke and company.