QE Stands for Quality Employment
Allianz Global Investors
By Kristina Hooper
September 17, 2012
It looks like the “QE” in QE3 stands for quality employment.
News that the Federal Reserve is embarking on a third round of quantitative easing dominated the headlines last week, pushing stocks higher, and capping a summer rally built on hopes it can reinvigorate the economy. The Fed’s focus this time is getting more Americans back in the workforce and lowering unemployment, which, in turn, should ignite growth. And while many market observers thought they wouldn’t be surprised by the announcement, they were. That’s because the latest round of easing is so open-ended and far-reaching.
To recap, the Fed will buy $40 billion of agency mortgage-backed securities per month. It will also continue two other programs: 1) extending the average maturity of its securities holdings (although only through the end of the year) and 2) reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. Together, these tools should increase the Fed’s balance-sheet exposure to longer-term securities by about $85 billion a month through the end of 2012. The goals are to put downward pressure on longer-term interest rates, specifically mortgage rates, and support the housing sector by encouraging home purchases and refinancing.
What makes this round of stimulus so different, and potentially more far-reaching, is that the Fed can increase asset purchases as needed, and the program is not tied to a timeline. The Fed will look to employment—more specifically the quality of employment—to gauge whether to ratchet up or down the program, and to decide when to end it. Interestingly, the Fed has implied a shift in its policy response by setting interest rates with a greater focus on unemployment and the economy, rather than inflation expectations, as it has done historically.
As Chairman Bernanke explained, “The unemployment rate came down last month because participation fell. That's not necessarily a sign of improvement…we want to see more jobs. We want to see lower unemployment. We want to see a stronger economy that can cause the improvement to be sustained.” In other words, it’s not just about employment, it’s about quality employment. Bernanke’s remarks reinforce the tone set at Jackson Hole several weeks ago, when he noted that unemployment was a “grave concern” and reminded us of the Fed’s somewhat unique dual mandate to “promote a return to maximum employment in the context of price stability.”
Pinning Hopes on Housing
Bernanke has previously acknowledged that the Fed can’t fix the economy through monetary policy alone, although he believes that it can impact unemployment. How? By supporting the housing market and buying mortgage-backed securities. The problem with this scenario is that it is dependent on another factor beyond the Fed’s control: lending standards. Tight credit policies for some borrowers remain an issue. But when asked about tight credit at Thursday’s press conference by a reporter sharing the statistic that only 1% of mortgages originated in the past 18 months came from borrowers with impaired credit, he posited that banks are reluctant to lend because they fear home values will decline. He believes that as the housing recovery continues, lending standards will ease.
Clearly, homeowners who are unable to refinance because they are “under water” in their mortgages will benefit from a recovery in housing prices. However, what it is unclear is whether improved home prices will dramatically change stiff loan requirements. The importance of looser lending standards is not lost on Bernanke: “that is one factor actually that could make our policy more effective rather than less effective over time, if more people have access to mortgage credit, more people can take advantage of the low rates that we're providing.”
Continued tight lending standards may not be the only wrench thrown into the Fed’s game plan. Other downside risks include a flare-up in the euro-zone crisis and a lackluster third-quarter earnings season. But perhaps the most overlooked obstacle is inflation. The Fed’s change in focus means monetary policy is now less sensitive to inflation, a dangerous proposition given the likelihood of greater inflation in the long term. Bernanke went to great lengths to explain that QE3 won’t cause inflation, but ignored the fact that we’re starting to see inflation for other reasons. While the consumer price index remains tame, the producer price index for August rose 1.7%, well above expectations. The summer drought and a rise in oil prices, along with heightened tensions in the Middle East, suggest we will see prices rise higher in the near term. So while the Fed may not have a hand in food and energy inflation, it does play a role in the negative real yields investors are seeing.
Generally, we’re not convinced of the FOMC’s view that inflation over the medium term will run at or below 2%. During periods of deleveraging, in which sub-par growth persists, the economy is more vulnerable to inflation surprises. Historically, commodity-generated inflation has often been the cause of spikes in overall inflation. So despite a forecast of relatively calm inflation, and especially given all the QE stimulation, we could see another inflation surprise in the short term.
We can only hope that lower interest rates boost the housing sector, help loosen lending standards, stimulate corporate spending and increase foreign demand for U.S. products. This is a tall order and there are many “ifs” in this scenario, but the flexibility and breadth of QE3 increases the likelihood of its effectiveness. The key takeaway from QE3 is that it reaffirms our view that we are in an era of financial repression. We continue to recommend asset classes that offer positive and significant real yields, such as fundamentally strong companies with robust, sustainable dividend yields. Like the Fed, we’re focused on quality too.
Kristina Hooper, CFP®, CIMA®, is head of portfolio strategies at Allianz Global Investors Distributors LLC.
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