QE3: What the Federal Reserve Bank's decision means for you

Today the U.S. Federal Reserve Bank voted 11-1 to launch QE3 a form of debt monetization, which means it is going to buy the Treasury's debt and monetize it by collecting the interest on that debt over the long-term. It keeps the money domestic, but there are good and bad consequences to their decision. Debt monetization is described in more detail in the video below.

Federal debt monetization explained

The Federal Reserve Bank has already created over $2 trillion dollars to purchase U.S. government and other debt via QE1 and QE2, the unemployment rate, which the Fed is mandated to lower, is still above 8 percent despite their actions. Oil prices, which are priced in dollars are nearing $100 per barrel. This is due in part to the liquidity created by QE1, QE2 and QE3.

To illustrate further, when the Fed creates money to buy assets, the total amount of money in the U.S. financial system increases one way or the other through their purchases from primary dealers. The result becomes higher gas prices, and inflationary pressure since oil is priced in dollars. 

Yet the Consumer Price Index is still only near 1.7 percent per the Bureau of Labor Statistics, why? The CPI is not a measure of inflation, but rather a measure of price in current dollars per the Mises Institute. An additional cost to consider is the cost of tax on the price of goods and services; when taxes rise are those included in the CPI? According to Shadow Government Statistics, a website that documents inflation using the Federal Government's previous official measurement of it, inflation is actually closer to 5 percent. You be the judge.

Below are some of the effects of quantitative easing.

• Equity inflation 
• Oil inflation
• Dollar devaluation
• Low bank savings rates
• Reduced cost of servicing national debt

The reason the stock market loves monetary liquidity is because more money made available via the bond purchases makes it way into various markets. That and the incentive to invest in bonds declines and encourages equity investment, until it doesn't.  The bi-product of the debt monetization is in effect a stimulus. However, the amount of that stimulus is slowly being racheted down. QE1 was  approximately $1.42 trillion, QE2 was $770 billion and QE3 is $160 billion through the end of 2012 per MarketWatch. Since Operation Twist only traded short-term government debt to long-term, it is not adding to the size of the Fed's balance sheet. Yet according to John Carney of CNBC, the terms of QE3 are much more flexible for the central bank.

Critics of quantitative easing have been vocal about the reduced effect, and potential destructive consequences of inflationary stimulus on the national monetary system and the economy. Zero Hedge describes current European monetary policy as "Desperate maladies requiring desperate measures" in a thought provoking analysis. The Fed itself has said it can't fix the economy and has called upon Congress to adjust its fiscal policy to address the massive national debt. The effects of quantitative easing on the American consumer are no joke.

How the Dollar has changed in the 21st century

The 21st century has brought new developments to the valuation and purchasing strength of the United States Dollar. Moreover, the dollar has declined in value in two ways. First, the domestic spending parity with goods and services has declined, and second, the dollars' valuation against foreign currencies not pegged to the dollar has declined. To illustrate, with increases in the consumer price index (CPI), an inflationary metric, a dollar will be able to buy less of what it could once purchase more of.

Image source: Przemyslaw Wojtkowski

Inflationary pressures such as increases in the cost of groceries such as milk and eggs, and transportation expenses are examples of variables within the CPI inflation measurement. In terms of valuation against foreign currencies, the dollar has also decline in value. For example, the Canadian dollar used to be valued significantly lower than the U.S. dollar while in 2007 and 2008 the Canadian dollar was valued at close to par with the U.S. dollar, sometimes higher than the U.S. dollar.

Causes of fluctuation in currency value

There are several reasons why currencies fluctuate in value. The causes in daily fluctuations are sometimes due to different reasons than longer-term changes in currency valuation. Essentially, but not in all cases, the more factors that influence a currency downward are present, the lower the valuation of the currency will go in terms of value in terms of foreign currency. In regard to purchasing power a similar correlation may be drawn. Moreover, when currency value declines, inflation protection is often necessary to preserve wealth. A few of the factors that influence the price of currency are listed bellow, several of which are influenced by monetary policy implemented by the Federal Reserve Bank.

• International confidence in the dollar
• Leveraged FOREX market movements
• Inflationary pressure
• Political developments
• Economic indicators
• Liquidity or Money Supply 
• Interest rates
• Commercial Market Conditions
• Global cash flow developments
• Return on Dollar Investments

Possible solutions to increasing the Dollar's value

Deciding what needs to be done to stabilize the value of the dollar and lower the inflationary pressure that affects purchasing power of the dollar is a multifaceted issue. The reason it is multi-faceted is due to all the influencing factors mentioned above. Changing just one variable is less likely to have a great impact on the value and strength of the dollar than transforming more than one or several variables. In other words, if U.S. Investments were to yield a higher profit in relation to other global investments and the economic stability and/or growth of the United States economy were to become more favorable, then the chances the dollar would rise in value would have a greater chance  had only the returns on investments in relation to foreign investments risen.

Currency valuation and purchasing strength is an indicator of domestic and global economic conditions, inflationary factors, and international investment confidence. When globalization began to accelerate, the United States was no longer the only place in the world that provided solid returns and stability to foreign investors. The emergence of global economic blocks such as the Euro zone, and Southeast Asia made investments in U.S. Government backed securities a less important option than other global investment vehicles. While this trend has become disturbing to economists, citizens and some politicians, the dollar continues to attract foreign investment, the trade deficit had declined, and the U.S. economy remains relatively stable despite an extended period of slowed growth and downward pressure on its value from monetary policy.

Summary

In some senses fear over the decline of the U.S. Dollar is justified while in other ways it is not. While some conditions that have led to the decline do warrant remedy and action, the situation may not be as dire as some believe. This is so as the United States remains the largest if not among the largest economies of the World and for good reason. Vast natural resources, a developed securities market, a massive economic infrastructure, internal political stability, commercially favorable regulatory environment and lower taxes than in the Euro zone still make the United States a great economy.

The U.S. Government is now facing large decisions as health care, security, infrastructure, international debt obligations and other expenditures outweigh cash inflow. These financial issues are likely to be addressed in one way or another in addition to the possibility of being buoyed by favorable industrial and commercial developments within sectors of the economy that allow innovation and product development to make the American economy the leader it has been and will probably continue to be for some time to come.

Are Federal Reserve Quantiative Easing Programs Helpful to Markets?

Quantitative easing is a term used to describe a form of economic stimulus offered by the Federal Reserve Bank to help boost market activity including business lending. This type of economic aid is an alternative to government funded investments, tax breaks and subsidizing. In the case of the U.S. Government, as of October, 2010, deficit spending has become so high that it has reached levels near that of World War II and the Great Depression. Hence, the assistance of the Federal Reserve Bank is seen as a viable alternative to increase business and lending activity. This however, may not be as beneficial to business and market activity as some predict for more than one reason.

The first reason quantitative easing by the Federal Reserve might not be as helpful as intended is method. On October 27, 2010, reports that the U.S. Federal Reserve bank would only place hundreds of billions of dollars into the economy via treasury purchases over three months caused concern. This is due in part to market psychology, and second, due to actual quantitative availability of funds for potential lending, spending and investment. Skeptics became concerned that a gradual and cautious approach to a second round of Federal spending in a way that did not mirror an earlier version was not the amount priced into market values.



Another reason why quantitative easing from the Federal Reserve Bank may not be as helpful to the U.S. Economy as expected is asset management. That is to say, if the balance sheet of large banks to whom federal funds will be available do not see good reason to spend, then they might not. This is evident in the early 2000's Japan pumped billions of dollars worth of Japanese Yen into its economy via a quantitative easing program of its own. However, the quantitative easing excluded the desired effect of strong economic stimulus. The reason for this according to a Federal Reserve report by Takeshi Temura and David Small was because of cautious asset management on behalf of banks i.e. financial intermediaries that didn't want to take on additional risk to their already risk tainted asset portfolios.

According to an October 27, 2010 MarketWatch interview with Jon Hilsenrath, a writer for the Wall Street Journal, when the Federal Reserve buys bonds via a quantitative easing program, it has an equivalent  affect as lowering the Federal Funds rate by 50-75 basis points or between .5-.75 percent. Since the Federal Funds rate was .25 percent in October, 2010, that would be similar to the effect of a negative interest rate in which the potential yields that banks could obtain from borrowing money would rise due to low cost. Instead, the larger availability of money is intended to increase market prices by encouraging demand. With higher market prices, comes a theoretical greater wealth, or wealth like affect on the economy.

In light of the above reasons, whether or not quantitative easing by the Federal Reserve bank will be helpful to the market depends on banking decisions in addition to borrowing activity. Without bank investment or increased lending activity, the intended purpose of quantitative easing may not be accomplished. Banks existing assets need to perform well enough to justify additional risk taking or additional risk taking has to be low enough to offset existing risky assets. If financial institutions decide the increased availability of money is to their advantage, they may see opportunities somewhere if not domestically, that on a medium to long-term time horizon may yield economy friendly banking profits.

Sources: (Date of record, October 27, 2010)

1. http://bit.ly/9E2cxu  (Wall Street Journal)
2. http://bit.ly/apVsC1 (Federal Reserve)
3. http://bit.ly/9J9tE0   (Federal Reserve Statistical Release)
4. http://bit.ly/bMqf39   (MarketWatch)