Long in coming and widely anticipated, the Fed announced September 13 that it would launch another effort to stimulate the economy through further monetary policy actions. The implications extend not to the tens of billions of dollars that will be spent on mortgage-backed securities, but also into the interest rate, equity and commodity markets, as well as the global economy.

Why, What and for How Long?
In response to what Fed Chairman Bernanke essentially described as an unacceptably weak job market, the FOMC has decided to launch further monetary stimulus. In addition to the ongoing "Operation Twist" (which will continue to year-end), the Fed will be looking to buy up to $40 billion a month in mortgage-backed securities. In addition, the Fed will apparently be looking to keep interest rates very low going into 2015.

With the combination of the new MBS purchase program and the ongoing Operation Twist, the Fed will be increasing its bond holdings by about $85 billion per month through year-end. Extending this out through 2013, Zero Hedge has forecasted that the Fed's balance sheet could hit $4 trillion by the end of next year.

While this is the third major round of actions of this sort, there were several aspects of the plan that were a little different. First, the plan is open-ended - targeted to continue "until economic conditions improve," though specific goals were not provided. Secondly, this is the first plan that has been launched with a specific target of improved employment. Last and not least, the Fed is launching this program while simultaneously expressing some general optimism about the economy (absent the employment situation).

How Will the Markets Respond?
Initial reaction to the Fed's announcement went along fairly predictable lines - stocks were up, bonds were up, the dollar was down, and hard assets such as gold and oil jumped.

In the past, low rates have spurred investors to load up on riskier assets (since the risk-free rates are so low) and there's little obvious reason to assume this time will be different. That does not mean that further momentum in the stock market is a given, though. While low rates encourage riskier investments, economic weakness scares investors, and enthusiasm for stocks won't last if companies such as Caterpillar, Boeing, Ford and General Electric lower their guidance and growth expectations. Likewise, low rates are a challenge for insurance companies and banks that do not increase their lending activity.

Hard assets such as gold should do well, as monetary stimulus essentially devalues the dollar and raises the risk of higher inflation down the road. It's more difficult to say the same about oil, which responds to other factors, such as political instability (like the recent riots in Egypt and Libya) and the global economic outlook. Property can also do well. While prior rounds of monetary stimulus have not led to soaring housing prices in the U.S., they have led to more money flowing to real estate in markets long Hong Kong.

Will the Economy Respond?
As I said earlier, the goal of this latest action is explicit - to bring down an unemployment rate that has been stubbornly high for several years now. In point of fact, the real unemployment rate is likely quite a bit worse than the 8% or so figure commonly cited. Instead, a look at the U-6 number suggests that real unemployment might be closer to 20%. Having so many people out of work, or inadequately employed, and weak demand for labor keeping wage growth so low has had a lot to do with the poor pace of the economic recovery, and it's not a big surprise that the Fed is targeting this metric.

If this policy works, it will be through encouraging consumers to borrow money at low rates and then spend it on goods and services, and encouraging businesses to use low rates to fund capacity expansions and hire more workers.

The big question, though, is whether this latest action will help. After all, QE1 and QE2 didn't boost employment (though an argument can be made that they kept the employment situation from getting worse), and interest rates were already low before this announcement. It also does nothing to address a basic problem in the economy - businesses are demanding workers with training in areas such as healthcare, computer science and specialized industrial skills (like welding), but the market is supplying a lot of liberal arts graduates and workers who didn't go to college (or in some cases, didn't finish high school).

Banks are also reticent to take on risk and lend, choosing instead to borrow cheaply and invest in securities. Likewise, many corporations are flush with cash, but reluctant to commit to expansion and hiring in the face of soft consumer demand and significant uncertainty regarding fiscal policy (taxation, budget deficits, government spending and so on).

There are also risks from this latest action. If this monetary easing leads to a rise in prices for commodities such as oil, natural gas and agricultural goods, it effectively works as a tax increase on consumers. Second, low rates and high "hidden" inflation are a powerfully negative one-two punch for retirees. Last and not least, deliberately manipulating interest rates lower is risky, as it interferes with the information and signals that the market is supposed to send to both consumers and producers.

The Bottom Line
More likely than not, this latest round of easing will spur fierce debate between those still committed to the Keynesian theory that the government needs to spend its way out of this malaise, and those steadfast in their belief that not only will this plan fail to improve employment, but it will also lead to dangerous inflation down the road. Although the present low velocity of money and low wage growth argue against serious near-term inflation, the problem with monetary policy moves is that the interval between action and reaction/response can be long and uncertain.

It's also worth noting that the Fed is only one part of the equation. While the Fed has gone "all in" trying to stimulate economic growth and employment, businesses and consumers are still waiting for Congress to make its move. More clarity on policies regarding taxation, budgeting, borrowing and infrastructure spending will be needed if the Fed's moves are to have any positive impact.

In the meantime, it seems reasonable to expect ongoing momentum in hard assets such as gold and silver, low interest rates and nervous balance in equities between a pro-risk low-rate environment and softening underlying fundamentals.

Related Articles
  1. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  2. Economics

    Understanding Income Inequality

    Income inequality refers to the uneven distribution of income across a single economy.
  3. Economics

    Who is a Hawk?

    In the economic sense of the word, a hawk is someone who believes high interest rates should be maintained to keep inflation low.
  4. Investing Basics

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  5. Investing

    Latin America’s Economic Forecast

    After a ten-year run, the economies of Latin America are in a decline. For sustainable, long-term growth, the region needs structural reforms.
  6. Economics

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  7. Investing Basics

    How to Use Boring CDs to Diversify

    Markets are volatile and are in for more punishment. CDs can help investors earn some interest while they're waiting out the storm.
  8. Investing

    Breaking Down the Federal Reserve's Dual Mandate

    The Fed has been tasked with a dual mandate by Congress to achieve monetary stability. We explain what the dual mandate is and what it means.
  9. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  10. Economics

    Should the Fed Be More Worried About Asset Bubbles?

    While the Fed should be concerned that assets bubbles might impact economic stability, monetary policy is not the best tool to mitigate this threat.
  1. Who decides to print money in Russia?

    The Central Bank of the Russian Federation (CBRF), like its peers in most countries, is the governmental entity responsible ... Read Full Answer >>
  2. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  3. Who decides when to print money in India?

    The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>
  4. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  5. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  6. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!