September 28, 2012 by Shawkat Hammoudeh
Quantitative easing is an emergency monetary policy used during recessions. The Federal Reserve plans to buy $40 billion every month in mortgage-backed securities in the open-ended QE3 until the labor market improves significantly. QE3 is the third round of buying long-term bonds that the Fed will be using to target unemployment, which is a very different target than interest rates. The Fed hopes that QE3 will help push down long-term borrowing costs and eventually stimulate lending, spending and hiring.
As part of its conventional policy, the Fed usually targets nominal GDP, money supply or short-term interest rates through intervening in the federal funds market. Targeting the labor market, however, is an unconventional task, and like quantitative easing, it is probably a more distanced target to strike than the conventional targets. It also means that the Fed believes that the high unemployment is cyclical and not structural, which is a debatable issue.
In my previous article, I argued that QE3 is more than a time-buyer because it is open-ended and uses creditability and long-term commitment to influence the economy. This is different from QE1 and QE2, which were announced to be closed-ended, and each lasted six months. A credible forward guidance is lacking in those two QEs. Still, QE3 has some elements of QE1, which included buying mortgage-backed securities to influence the badly troubled housing market, but QE1 did not succeed in this regard.
Although the Fed’s ultimate goal of pursuing high unemployment may not be easy, it should succeed through keeping the dollar weak, which has made exports one of the growth engines of this lackluster recovery. With QE3 the Fed may be able to stimulate the housing market this time, something it could not do with QE1. As I indicated earlier, QE3 has credibility, commitment and open-endedness on its side, and if you believe in the success of expectations under those circumstances, you may give QE3 a higher grade than QE1. QE3 may work through the inflation expectation channel by inducing lower real interest rates. The Financial Times just reported that inflation expectations have increased for the first time since 2006 and are near the all-time closing peak of 2.78 percent from March 2005. Moreover, the housing market is different now than it was three years ago when QE1 was announced. There are reports that this market has started to reduce the housing overhang and may soon experience shortfalls. Furthermore, housing starts and building permits are climbing up. What’s also different now is the upswing in the mobility of people and the number of young men moving out of their parents’ homes, according to the 2011 census data; both are signs that more young adults have been testing out job prospects. Overall we can say that the multiple downsides of the Great Recession have bottomed out.
The combination of credibility, commitment, open-endedness, an apparent shortfall in construction, and upswings in the mobility of people may work in favor of QE3 this time. If the housing market starts to recover, then we will have another engine of growth in addition to exports. With two growth engines, the post-Great Recession recovery may turn into a standard recovery, and things will fall in place for a much stronger recovery. Ultimately, the labor market will benefit, and unemployment rate may drop close to 7 percent by the end of 2013.
Shawkat Hammoudeh is a professor of economics and can be reached at [email protected]