Fed’s Big Bet: Will it Work?

On Thursday, the Federal Reserve gave Wall Street exactly what it was looking for: another round of aggressive quantitative easing in an effort to re-ignite the lackluster economic recovery.

After its two-day meeting, the Federal Open Market Committee announced a fresh round of easing, or QE3, including massive purchases of mortgage-backed securities. In addition, the central bank pledged to keep short-term interest rates at record lows through mid-2015.

With the unemployment rate still above 8%, lackluster consumer spending and a persistently weak housing market, Wall Street and Main Street were hungry for more action from the Federal Reserve. The markets seem appeased with the action as the Dow Jones Industrial Average rallied 207 points, the S&P 500 closed up 23.4 points and the Nasdaq jumped 41.5 points on Thursday -- but doubts still remain about whether the Fed’s actions will create a sustainable recovery and calm consumers’ jitters.

Fed watchers and Wall Street were not surprised that the Fed unleashed more easing. In fact, Fed Chairman Ben Bernanke gave several hints the bank was planning on hefty action in his speech in Jackson Hole, Wyo., at the end of August. However, the open-ended nature of the plan is considered unconventional and unprecedented.

“The aggressiveness and the precedent-setting nature of being opened ended was a surprise, and the markets took it that way,” said David Jones, president of DMJ Advisors and a former Fed economist. “It’s incredible that it’s been almost four years and we’ve seen the Fed repeatedly acting to increase accommodations whether it’s cutting the federal funds rate or these large-scale purchases.”

The Fed hopes its plan to buy up to $40 billion a month of mortgage-backed securities will drive down longer-term rates, including mortgages, and lure in homebuyers and provide more stability to the housing market.

“The idea here is that if they buy these securities it will keep mortgage rates low and give banks the capacity to issue more mortgages,” explains Nick Colas, ConvergEx Group chief market strategist. “But this isn’t our first rodeo, we’ve been trying to do this for three years now and the best thing we can really claim is that we haven’t fallen into a deep recession, but we can’t claim victory.”

With mortgage rates already sitting at record lows, experts are skeptical on the boom QE3 will create.

“Housing rates have dropped to as low as 3% for 30-year mortgages; if people aren’t buying at 3%, how much more are they going to buy at 2.95%?” questioned Tim Yeager, associate professor at the University of Arkansas Walton College and Arkansas Bankers Association Chair in Banking.

However, he said the massive buying spree could attract more investors into the market. “If the Fed is buying more safe assets like the MBS, it pushes the yields down and encourages others in the market to pursue riskier assets. The market is speculating that more people will put more funds in the stock market rather than in safer types of bonds.”

Limiting the buying program to mortgage-backed securities could help underwater homeowners and attract more buyers, but there could be other reasons for the narrow scope.

“There’s a political component,” says Colas. “The Fed was criticized under QE1 and QE2 for buying bonds that were just issued the week before, which is a safe strategy. These purchases are not as politically loaded as Treasury securities.”

Jones said QE3 will not do much to repair the housing market as a whole, but will benefit certain banks.

“This whole buyback issue is more of a significant issue for the financial institutions that were involved in the huge amounts of subprime mortgage securitizations that were going on. You’re talking about a handful of bigger banks that have disappeared off the face of the earth by merging into others.”

Bernanke said the bank will continue the bond buying program until the job market stabilizes. "We are looking for on-going sustained improvement in the labor market," Bernanke said during a news conference Thursday. "There's not a specific number in mind. But what we've seen in the last six months isn't it."

The Fed is hoping lowering borrowing costs will encourage lending, induce spending and lead to more hiring.

"The Fed only has two mandates,” said Colas. “The first is price stability and the second is full employment- -- it’s a short menu. As for the legal requirements, inflation hasn’t been really a risk so they have to focus on that other mandate. But what they are trying to do is conduct open-heart surgery and using a very crude tool to target a very specific purpose.”

The massive amount of money the Fed is injecting into the financial system is targeted to eventually hit consumers, but it may take some time.

“Money gets pumped into financial system and a major piece of it goes into stocks, and then stocks will rise, which provides wealth to those who own equities and provides confidence to businesses and managers who will then feel comfortable and will hire,” said Colas.

But the jury is still out on whether this action will really help or if the money will make it down to consumers.

“It’s going to have small effects on the labor market,” said Yeager. “The labor market depends on GDP growth and until that is stronger, the labor market isn’t going to improve quickly. The Federal Reserve has already exhausted most of its ammunition and they only have a few pieces of ammunition left and these  aren’t as powerful. They’ve already lobbed all their bombs, and now they are just firing from a handgun and it’s not going to have nearly as big effect on labor market.”