The Fed Announces QE3, Or Something Even Bigger

The Fed put out about as dovish a statement today as could be expected.

The Fed will purchase $40 billion of mortgage-backed securities every month until the economy improves (as judged by the Fed). In addition, the Fed promised even further stimulus if the economy doesn't improve, and to keep interest rates at zero until after a recovery takes hold.

This bold move is already being dubbed QE3, but that doesn't quite capture the extent of what the Fed's doing. "Quantitative easing" refers to a nontraditional monetary policy tool: the Fed providing monetary accommodation by specifying an amount of assets it will buy. Normally, the Fed eases (or tightens) monetary conditions by lowering (or raising) short-term interest rates. With the rate it usually targets at zero, however, it can't loosen money supply by lowering rates any further, creating a need for other forms of easing.

In this case, the Fed specified an amount of securities it will buy: $40 billion per month, versus the $600 billion total for QE2. More importantly, though, the Fed also stipulated that the purchases will continue -- and the rate of those purchases even increased -- until there's a real economic recovery (although it declined to spell out exactly what would constitute a recovery).

So it's quantitative easing, but also another kind of easing, tying asset purchases to economic conditions.

The difference between the two lies in the fact that the Fed's promise to continue buying mortgage-backed securities and other securities if needed until the economy recovers sets expectations for the market and reduces monetary policy uncertainty. With QE2, the Fed announced $600 billion of bond purchases, and then let the market guess at what the macroeconomic result would be. With this latest move, it guaranteed not only the number of purchases but also the end result of those purchases, allowing investors to set their expectations without having to try to forecast the Fed’s behavior.

As I've previously written, monetary policy uncertainty is the greatest source of policy uncertainty holding back investment and hiring in today's economy. By committing to bond purchases and low rates until after the recovery has taken hold, the Fed has ended investors' guessing game about the Fed's reaction to each jobs and GDP report.

So in addition to large-scale asset purchases, this latest Fed action will move the market through expectations-setting. As a result, QE3 will likely be far more significant than QE2 was, even if it ultimately involves fewer bond purchases.