Learning how to live with open-ended QE

FEDERAL Reserve chairman Ben Bernanke last week did what the markets had been waiting for. He announced that the US central bank would be rolling out another round of its controversial quantitative easing program (QE3). The Fed will commit to monthly asset purchases of $40bn (£ 24bn) until a substantial improvement is seen in the US labour market. This move effectively paves the way for an open-ended asset purchase programme, with no horizon in either time or amount.

The move had all of the anticipated effects on the market in the short term. Risk assets were boosted – assets jumped and commodities posted multi-month highs. But while short-term market exuberance was not unwanted, it was not the aim of QE. For QE to meet its stated objectives in any form, it must boost the labour market and in turn give US consumption a shot in the arm – something that the two previous programmes have failed to achieve.

The move is a bold one – according to calculations for Bank of America, the Fed will own more than 33 per cent of the entire mortgage market by 2014. If ever the Fed wishes to tighten its policy, it will be unwinding a balance sheet of 24 per cent of US GDP.

It should also be remembered that the Federal Reserve has a dual mandate – concerned with inflation as well as employment. And you do not have to look far to find criticism of the programme on both fronts. Richmond Federal Reserve President Jeffrey Lacker was the sole dissenter on the Federal Open Market Committee’s (FOMC) decision, but has he dissented at every FOMC meeting this year, stating that he believes that QE3 will do very little to boost the labour market. “The effects are very hard to gauge, but my sense is that this is going to have a greater effect on inflation and a minimal impact on jobs,” said Lacker in a radio interview, last week.

Though the form of QE may have changed in some regards, the investor play on the inflation worries that the programme throws up has changed little. When there is a US inflation fear, then gold is a buy

Bernanke’s critics have no end of accusations to level at him, from the debasement of the currency to fanning the flames of inflation and papering over the cracks. But one of the biggest effects that QE has had on the nature of trading fundamentals is the breakdown of the connection between macro data and the real economy. This was especially the case in the months preceding last week’s QE announcement, as markets abounded with speculation as to when, and if, Ben Bernanke would order more QE. Bad news was seen as good news and moderately good news was seen as bad. If the nonfarm payroll number showed another disastrously low figure, then that was a good thing – Ben Bernanke was more likely to dump money on the economy from his helicopter.

“An important driver of this attenuated market response to economic news was the sense that important elements of the monetary policy framework were ‘in play’, and that policy was likely to respond if the economy weakened sufficiently, but not otherwise,” explains a note from Barclays Research.

But this good news/bad news disconnect may have been ended by last week’s moves. There is no more speculation. If there is bad news then it is bad news. Unlike the first and second rounds of QE, there is no stated end date for QE3 on which the markets can focus. As a result, market participants will need to learn to live with ongoing QE of this kind and not expect any extra liquidity injections on the horizon.