You, me, + QE3

One Cent’s Worth
By MARC MEWSHAW  |  October 3, 2012

After two previous rounds of qualitative easing, the floodgates have opened for yet another. The Fed will now begin pumping $40 billion a month into the US economy, and continue doing so until chairman Ben Bernanke sees an improvement in the country's flat-lining recovery.

Not surprisingly, this announcement has drawn protest from both wings of the political spectrum. The question on many lips: what makes us think QE will work now when it's failed twice before? Let's not be so quick to prejudge QE3. For all their outward similarities, QE3 and its predecessors are very different.

To get a handle on some of those differences, let's revisit the issues that QE1 (and to a lesser extent, QE2) were designed to address:

• Banks had accumulated a bunch of toxic assets in the subprime mortgage crisis.

• The global economy had seized up because banks weren't lending.

• The objective of QE1 was to get banks lending again by taking those bad assets off their hands in exchange for cold hard cash that the Fed had conjured out of thin air.

Let's not mince words: QE1 was a thinly veiled bank bailout. And, guess what? It backfired. Instead of loaning that money out as they were supposed to, banks sat on it, more interested in ensuring their own survival than in repaying the Fed's lifesaving favor by helping the economy.

But that was 2009. This is 2012. The picture has changed dramatically.

• The issue is no longer lack of liquidity but low consumer confidence. Toxic assets have more or less been flushed from the financial system. Banks have brimming reserves to lend from and the will to do so. But businesses and consumers don't want to borrow to make big purchases — a natural enough reaction in uncertain times. And that financially conservative instinct also affects how people are choosing to invest their money.

• The sluggishness of the housing market. The ongoing perception that buying a house isn't a good investment means that the housing sector, one of the key engines of economic growth, continues to flounder.

How is QE3 meant to treat those ills? With some carrot and a whole lot of stick:

• QE3 will keep interest rates at near-zero at least until mid-2015, enticing consumers to borrow more — in theory. And, perhaps, with their cash earning negligible interest in savings accounts, people will be more inclined to spend it or invest it aggressively.

• With the $40 billion the Fed is printing up each month, it will buy mortgage-backed securities, driving mortgage rates even lower.

• By encouraging more home-buying, the Fed hopes to boost employment rates. Larger demand for homes means more people getting hired to build houses, drive delivery trucks, work at lumber mills, and the like.

• Lastly, QE3 waves a big scary stick over people's heads. In unsettled times like these, people tend to seek refuge in conservative investments like bonds. But as the Fed buys these bonds up — as it plans to do with that $40 billion — it drives up their prices by reducing supply. As a consequence, the return on that investment decreases. If you keep your money parked in bonds, inflation outpaces your returns, so over time, the value of that investment actually shrinks. That creates a strong incentive for folks to plow money that's now safely locked up into riskier assets, like stocks, that offer the promise of better returns. And that's what Bernanke wants because greater participation in the stock market boosts the economy in myriad ways.

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