Phillip L. Swagel
Senior Fellow; Professor, University of Maryland School of Public Policy
Banking and Capital Markets and Global Economy and Public Policy and Real Estate and Regulation and U.S. Economy
Dr. Phillip L. Swagel is a professor at the University of Maryland School of Public Policy, where he teaches classes on international economics and is an academic fellow at the Center for Financial Policy at the university's Robert H. Smith School of Business.
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QE3: Letting congress and the president off the hook?
By: Phillip L. Swagel
September 14, 2012
As expected, the Federal Reserve announced on Thursday that it would seek to boost the economy through the combination of asset purchases to drive down long-term interest rates and assurances that Fed policy would remain at an expansive setting for nearly three more years. The third round of quantitative easing, or QE3, involves purchases of $40 billion per month in mortgage-backed securities. Together with the existing program of aEURoeOperation TwistaEUR? to purchase long-term Treasury bonds, this amounts to about $85 billion in Fed demand for long-term assets. The Fed made clear that it would do more if the economic outlook remains weak.

The Fed's action was foreshadowed by Chairman BernankeaEUR(TM)s August speech at the Kansas City FedaEUR(TM)s annual Jackson Hole conference, which set forward the case that Fed action could be effective and dwelt on the negative impacts of the weak job market and especially of the dangers of long-term unemployment . In a press conference following the announcement of the Fed decision, Chairman Bernanke made clear that the Fed action is far from a cure-all. Indeed, he has consistently called for fiscal policy to play a role as well, in both the near term by avoiding a contraction but then over time by putting into motion a credible set of policies to address the looming U.S. fiscal imbalance.

By itself , without this supportive mix of fiscal action across multiple horizons, the Fed action should be expected to provide only a modest to boost business or consumer spending. This is not a surprise. After four years of low interest rates, it is hard to imagine that businesses will suddenly start to invest or hire if QE3 drives down borrowing costs by another 20 or 30 basis points. The same for consumers: mortgage interest rates are already at historical lows. It is too much to expect a sudden housing boom from another half-percentage lower rate.

Even so, the Fed is acting because it is the only game in town and because the weak job market means that there is little near-term danger of galloping inflationaEUR"the huge number of unemployed workers will keep down wage growth and thus inflationary pressures, though some price rises are to be expected from commodities.

The Fed statement made clear that further action would be taken if the economy did not recover, though the requirements or actions were left unclear. Current forecasts are for a continued recovery but at a moderate pace with GDP growth of 1.5 to 2 percent per year. This is not enough to make a rapid dent in the unemployment rate or lead to strong job creation. Whether the Fed acts, then, will depend on both the economic outlook and on its view of whether the potential benefits of additional actions outweigh the costs.

A potential next step could be for the Fed to provide low-cost financing for specific activities such as consumer or business spending. This would be along the lines of a program in the UK by which the Bank of England gives low-cost funding to banks that actually increase their lending. Another approach would be for the Fed to do the lending itself, as it did during the financial crisis with programs such as the TALF (Term Asset-Backed Loan Facility) that directly targeted certain types of lending, such as credit card and automobile loans. These programs, however, are more complicated than buying mortgage backed securities or Treasury bonds and thus take longer to design and implement. They also present risk for the Fed, which could become exposed to losses if it turns into an all-purpose lender and there is another downtown.

Chairman BernankeaEUR(TM)s call for fiscal policy to complement the FedaEUR(TM)s actions suggests that he prefers to avoid such entanglements. An irony of QE3, however, is that the program likely allows Congress and the President more breathing space during which not to address fiscal problems. After all, with the Fed willing to buy huge dollar figures worth of Treasury bonds, this creates an easier environment for the Treasury to borrow. This would especially be the case if Treasury takes the opportunity of a ready buyer for Treasury bonds to shift the composition of this borrowing toward ever-longer horizons. Perhaps a 50- or even 100-year Treasury bond is in the offing.

In this season of elections and fiscal gridlock, the Fed is the only game in town for taking action with a chance of spurring a faster recovery. There might be only modest prospects for the latest Fed actions to have an impact, but Chairman Bernanke has shown that he wants to try. The Fed is in the game.