Fed Plan No Magic Bullet

The Fed's newest bond-buying plan has the potential to help, but investors should consider the risks before becoming too exuberant.

Jeremy Glaser 03.10.2012
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After months of fevered speculation, the Federal Reserve on September 13th announced its new bond-buying program aimed at boosting employment, assisting the housing market, and trying to help the economy grow strongly again. The market cheered the move. But will the program work, and is the enthusiasm warranted? Certainly, the move could make a discernable difference in the economy. This of course doesn't mean that more easing is an economic panacea and has no risks, or that the Fed can do all of the heavy lifting to boost the economy.

Building Up the Housing Sector
Unlike pervious easing plans, this new one is explicitly focused on employment. This shouldn't be a huge shock. The Fed has a dual mandate to both keep inflation low and employment high, and only one of those is a major problem at the moment. One of the key ways the Fed is planning to boost job growth is by stimulating the long-suffering housing sector. By buying $40 billion of mortgage-backed securities every month, the central bank is hoping to push mortgage rates even lower and entice more people into the housing market. The hope is that this will jump-start construction and begin to bring back some of the housing jobs that were lost during the bust. This isn't a crazy idea. Housing is one part of the economy that can absorb a huge number of new jobs, it is already showing emerging signs of strength, and it is highly leveraged to the financing environment.

Beyond just targeting a potentially job-rich sector, the Fed is explicitly tying the end of the program to an improvement in the labor market. It will keep buying bonds every month until the outlook for the labor market improves "substantially." By explicitly tying the program to the labor market, Fed officials are making it crystal clear that they see the weak job market as a major problem and that they will remain in the market until it is fixed or inflation gets out of control (more on that later). This open-ended commitment is a departure from previous rounds of stimulus where the Fed committed to a prescribed dollar amount of buying. In the past the market would have to wonder when (or if) the Fed was going to act again. If you trust the Fed's commitment to stand by its policy statements, then a lot of those questions and uncertainty disappear with this longer-term commitment. Add in the pledge to keep rates low through 2015, and it appears that this program is an even stronger commitment to act than the Fed showed in the first two rounds of easing.

Although this plan can (and likely will) be effective, it is far from a slam dunk. Monetary policy is a blunt tool. It just happens to be the one that is in the Fed's arsenal. Lowering rates and potentially expanding lending might not create a huge turnaround in housing. When was the last time you heard someone say that high rates were the reason they weren't buying a house? Unless the Fed's program can convince banks to greatly expand their lending bases, the effectiveness will be muted. Issues with consumer confidence, low household-formation rates, lack of savings for down payments, and other issues aren't going to evaporate with these bond purchases. It will help the housing market, but it will still take a long time before housing is back to normal.

Inflation Ahead? 
Inflation is another potential issue with the plan. Although inflation has remained relatively tame, this plan does increase the chance that price levels could rise much faster in the future. The Fed is in uncharted waters with its open-ended bond-buying program on top of its already hugely expanded balance sheet. We just don't know exactly what the impact is going to be. Expectations for inflation are also likely to go up because the central bank is now explicitly saying that it isn't going to start tightening policy at the first sign of economic strength. Instead, it will see that improved outlook merely as its cue to stop buying bonds, not to start raising rates. Fed officials now seem ready to keep rates very low, even when the economy is close to being back in full swing. 

The Fed might very well see slightly raising expectations for future inflation as a feature and not a bug of the plan. It has the potential to reduce real debt loads and protects against deflationary pressures. But balancing a slight increase in prices from a very damaging one is going to be extremely tricky to get right. The exit strategy from these extraordinary measures, and the impact of that strategy on savers, is one of the biggest question marks hanging over the Fed. Hyperinflation seems very unlikely, but a price level rising at a faster clip than we've been used to during the last few years is a real possibility. 

Beyond the Fed
Investors should also keep their expectations in check because the Fed just doesn't have the ability to fix the entire economy on its own. Congress needs to figure out how to solve the fiscal cliff and put the country on a sustainable fiscal path. We also have to hope that Europe doesn't squander the progress it has made in the past couple of weeks toward solving its debt crisis. And there remains the big question mark about how China is going to be able to transition to a more sustainable growth rate and what impact that could have on the rest of the global economy.

Overall, the Fed's new bond-buying program could help the economy. It is targeted at a real problem (unemployment) and should have an impact on an industry (housing) that has the scale to make a difference. But there are still serious risks to this unprecedented, open-ended commitment as well as other risks to the recovery that investors need to carefully consider before becoming too exuberant.

Jeremy Glaser is the Markets Editor for Morningstar.com.

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Jeremy Glaser  Jeremy Glaser is the Markets Editor for Morningstar.com.

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