Federal Reserve Chairman Ben Bernanke delivered what the markets yearned for, another round of quantitative easing.
At the end of its two-day meeting on Thursday, the Fed announced the launch of a new bond buying program. This is the third round of bond buying program that the Fed has implemented in its efforts to stimulate the U.S. economy. QE3, as the new bond buying program is popularly known as, is the Fed's most aggressive stimulus program since the financial crisis of 2009.
The Fed said that it will purchase $40 billion of mortgage-backed debt each month until there is a significant improvement in the labor market. With this, the central bank has basically put economic growth ahead of its mandate of maintaining price stability. Chairman Bernanke said that the Fed is looking for ongoing, sustained improvement in the labor market.
Bernanke had raised concerns over the labor market at the Fed's annual symposium last month, and hinted that the central bank was open to another round of quantitative easing. As I had said previously, the Fed would likely go ahead with another round of quantitative easing if the August nonfarm payrolls data is weak. The report released last week showed that nonfarm payrolls rose only 96,000 in August. With such dismal numbers, there was no way that the central bank was going to hold back.
Risk assets rallied on Thursday as investors cheered Bernanke's decision, with the benchmark indexes in U.S. finishing at multi-year highs. Gold prices also surged and are close to their 2012 high.
Benchmark's Rally After QE3 Announcement
Source: Washington Post
Risk assets had rallied in the previous two rounds of quantitative easing, so the rally on Thursday does not come as a surprise. The Fed's decision to implement QE3 is likely to result in a strong year-end rally in equity markets. But the big question is: will QE3 have the desired impact on the economy? I think it will.
Let's start with the labor market. Unemployment has stayed above 8% since February 2009 even as some other areas of the economy have shown some improvement. In fact, U.S. companies are sitting on huge piles of cash. Take Apple Inc. (AAPL) for example. The technology giant had $117 billion in cash reserves at the end of June quarter. Despite have strong balance sheets, companies are shying away from making investments that could boost jobs growth. What is holding back these companies is economic uncertainty. With QE3, the Fed has ended a great deal of that uncertainty.
Unlike the previous two rounds of quantitative easing, QE3 has no end date. The Fed's move shows that it is going all out in its efforts to prevent the U.S. economy from weakening. This should give businesses the confidence to invest and hire more people. This would bring a significant improvement in the labor market.
QE3 will also boost confidence among U.S. consumers. Consumer spending is one of the pillars of the U.S. economy. However, consumers have been holding back mainly due to concerns over the labor market. Many U.S. retailers have been hard hit by this trend. Lowe's Companies, Inc. (LOW), the second-largest U.S. home-improvement retailer, closed down 27 stores, cut jobs and lowered its profit forecast. Although reported August sales were better than Street estimates for retailers like Target (TGT), Limited Brands (LTD), Costco (COST) and Macy's (M), consumer spending has been lackluster overall. However, if QE3 achieves its target of sustained improvement in the labor market, then consumer confidence will increase, boosting spending. Increasing consumer spending would give businesses even more confidence to invest and hire.
By buying mortgage-backed securities, the Fed is also looking to drive down mortgage rates. According to Bernanke, this would create more demand for homes and more refinancing. The U.S. housing market has bottomed out and has been seeing a gradual recovery. The Fed's move is likely to accelerate the pace of recovery in the housing market.
The Fed expects the labor market to see marked improvement by 2014. The central bank expects unemployment rate to fall to between 6.7% and 7.3% by 2014. In 2015, the Fed expects unemployment rate to fall between 6% and 8%. The central bank also expects growth to improve to 3% next year and 3.8% in 2014.
The Fed's latest effort to spur economic growth is facing some criticism, including from Republican Presidential candidate Mitt Romney. However, the criticism is unwarranted. The Fed has taken the right decision by putting economic growth ahead of its mandate of price stability. One just needs to look at Japan's example to understand why the Fed is right. Japanese policymakers have been blamed for doing too little too late to shore up the economy, which led to a lost decade of growth. If the Fed had refrained from doing QE3, the U.S. economy would have likely seen years of sluggish recovery.
The Fed has done its part and now the onus is on lawmakers in Washington. The looming fiscal cliff is a major concern. Unless the Congress reaches an agreement on cutting the fiscal deficit, the U.S. economy faces $600 billion of tax increases and spending cuts. This could have a severe impact on the U.S. economy and could neutralize QE3's impact. Last month, the Congressional Budget Office said the fiscal tightening of that size could lead a recession.
The Fed has played its part in reviving the economy. It's now up to Washington to play its part.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.