Stocks surge on Fed’s QE3 plan

September 13, 2012

Financial markets soared Thursday after the Federal Reserve announced its new program to buy financial assets to inject money into the U.S. economy.

The surge began midday, as the central bank unveiled its third round of quantitative easing, or QE3. The S&P 500 climbed 1.6 percent, to close at 1459.99. The Dow Jones industrial average jumped 206 points, or 1.5 percent, to 13,539.86. Both indicators closed at their highest levels since December 2007.

For weeks now, financial markets have been expecting the Fed to take some action to stimulate the economy. But few observers expected that the central bank’s moves would be so dramatic. Previous quantitative easing efforts have been limited jolts, but the Fed is now saying that it will continue to act until the labor market improves “substantially.” That open-ended commitment was a radical break with past practice.

Even as Fed Chairman Ben S. Bernanke was explaining himself, economists and politicians were assessing the scope and meaning of the surprising news.

Michael Feroli, chief economist of JPMorgan Chase, noted that Bernanke has radically changed his approach to monetary policy: “Whereas past actions were, by and large, one-off adrenaline shots, today’s actions more fully embraced conditional commitment as the guiding principle behind Fed strategy.” Feroli predicted that the Fed would eventually move to an explicit rule where it promises to engage in stimulus measures until, say, unemployment reaches a certain level.

Economist Mark Thoma noted that Bernanke may have been swayed by a critical paper written in early September by influential monetary theorist Michael Woodford of Columbia University. That paper, Thoma wrote, showed that “the Fed has the most impact on the economy when it credibly commits to future actions. Thus, according to Woodford, it is not the quantitative easing itself that helps the economy (i.e. how many assets the Fed holds), but rather it’s the commitment to continue purchasing assets until the unemployment rate improves substantially that matters.”

●In a statement, Woodford himself praised Bernanke’s efforts: “They are still not as explicit about the conditions that will justify policy normalization as I would have recommended, but this is nonetheless an important and useful step, which should be more effective in increasing confidence that the economy will recover.”

Scott Sumner, an economist at Bentley University who has long argued for more aggressive Fed action, said the market rally proves the Fed can boost the economy merely by shifting expectations: “Even a very vague and inadequate promise from the Fed was enough to boost markets significantly.” He also predicted that the Fed appeared to be taking “baby steps” toward a new approach to monetary policy in which it targets a certain level of nominal growth.

David Wessel of the Wall Street Journal pointed out the gloomy news: Even after more easing, the Fed is still predicting that the economy will remain in rough shape for years: “Even with QE3, Fed sees jobless rate above full-employment (5.2%-6.0%) through 2015.”

●Given the weak economy, that might mean the Fed will have to keep QE3 alive for years. An analysis from Capital Economics found that, judging by the Fed’s own projections, the central bank will have to buy more than $1 trillion in mortgage-backed securities over the next three years just to get unemployment down to 7 percent.

●At his news conference Thursday, Bernanke agreed that “monetary policy is not a panacea.” He also pointed out that Congress could still squelch the recovery by allowing the series of tax hikes and spending cuts known as the fiscal cliff to kick in at the end of the year. “If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.”

Mitt Romney’s campaign criticized the move: “The Federal Reserve’s announcement of a third round of quantitative easing is further confirmation that President Obama’s policies have not worked. After four years of stagnant growth, falling incomes, rising costs, and persistently high unemployment, the American economy doesn’t need more artificial and ineffective measures. We should be creating wealth, not printing dollars.”

●But Justin Wolfers, an economist at the National Bureau of Economic Research, argued that if Bernanke was trying to help out Obama, he had an odd way of showing it: “There’s no sense in which the Fed’s move today was political. If they wanted to help Obama, they would have done this months ago.”

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