Will The Federal Reserve Unleash QE3 Soon?

Includes: DIA, QQQ, SPY
by: George Liu

The investment community has been abuzz lately with commotion over what actions the Federal Reserve will take to attempt to spur slowing domestic economic growth. More specifically, the investment community has been anticipating a third round of quantitative easing, the policy of outright purchasing securities on the open market in hopes of increasing the money supply to stimulate the economy through increased lending and liquidity.

Thus far, the Federal Reserve has been reluctant to initiate a new round of quantitative easing. The Federal Reserve board met this Wednesday and the results were somewhat anticlimactic. After deliberation, the committee decided to settle with renewing Operation Twist, which was due to expire later this month. Operation Twist involves the Federal Reserve selling medium-term bonds and using the proceeds to buy longer-term ones, which in turn "should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative."

With the Federal Reserve declining to unleash another round of quantitative easing this past meeting, investors are continuing to wonder if it will do so in the near future. However, without significant deterioration in the global economy, the Federal Reserve would be reluctant to do so anytime soon. St. Louis Fed Bank President James Bullard has stated that Federal Reserve policymakers would need to see "a pretty high hurdle" before unleashing QE3. So far, this "pretty high hurdle" is nowhere to be seen.

Domestic economic data is definitely weak. Goldman Sachs recently decided to recommend shorting the S&P 500, partly due to weak economic data coming from the Philadelphia Federal Reserve. The Federal Reserve also has had to cut projections for domestic GDP growth to 1.9%-2.4% compared to the 2.4%-2.9% gain predicted in April. However, the economy is still, despite a slowing recovery, growing at a point the Federal Reserve deems acceptable. The PMI Manufacturing Index came in at 52.9 for June, which is, although below consensus estimates, solidly above 50 (meaning there is overall growth). The Conference Board Leading Economic Index was also up slightly in May, which reflects that the U.S. economy is growing modestly. Moreover, the Federal Reserve's newly established 2-percent inflation goal is also a potential problem if quantitative easing is initiated, as increasing the money supply to the U.S. economy will also increase inflation.

Recent developments in Europe have been somewhat positive. New Democracy has set up a coalition government in Greece and the troika have signaled that they were willing to renegotiate parts of the Greek bailout, although it remains to be seen if the new Greek government can succeed where the previous Greek government failed. Moreover, Spain came out yesterday announcing that the audits of its banking system has concluded that, in a worst case scenario, Spain's banking industry would require 62 billion euros, which is on the low end of previous estimates by the IMF and is well within the 100 billion euros the Eurogroup set aside for a Spanish bailout. Moreover, Italy, France, Spain and Germany recently agreed to push European leaders to sign off on a 130 billion euro plan aimed at increasing growth in Europe's beleaguered economies.

Finally, the Federal Reserve has also been plagued by politics, or more specifically, a desire to stay apolitical. Election season is heating up and the Federal Reserve doesn't want to get caught in the political crossfire. Instead, Federal Reserve policymakers want to keep the Federal Reserve nonpartisan; thus, any major action, such as quantitative easing, the bank takes will definitely be scrutinized by some through political lenses. Capital Economics, a research firm, has noted that, historically, the central bank does not change its monetary policies ahead of presidential elections.

Overall, barring drastically negative developments in the domestic and international economies, don't expect the Federal Reserve to initiate quantitative easing anytime soon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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