This is a transcription of Quantitative Easing (QE3) Announced: Now What?
Quantitative Easing (QE3) Announced: Now What? This is the transcription of the Mullooly Asset Management Podcast from September 19th, 2012. You can listen to the podcast by clicking the previous link or by visiting iTunes.
Brendan: Hello and welcome to the Mullooly Asset Management podcast for September 19th, 2012. This is Brendan from Mullooly Asset Management. Today we will discuss with Tom Mullooly, the topic of quantitative easing.
Tom, last week, the Federal Reserve announced a new round of quantitative easing. Can you briefly describe what quantitative easing actually is for our listeners?
Tom: Well, the Federal Reserve only has so many plays in their playbook. They can raise rates and lower interest rates, they can raise the cost for banks to borrow money from the Fed, they can lower the cost for banks to borrow from the Fed. The Fed is the banker’s bank.
They can also do things like purchase bonds in the open market and they can sell bonds to kind of help, maintain the level of interest rates and keep the economy moving.
Brendan: Okay, Tom. So as I understand it, the Federal Reserve is not actually part of the federal government. So how was the Federal Reserve created and more important, why was the Federal Reserve created?
Tom: All right, that’s a great question. The Federal Reserve was created back in 1913 by an act of Congress, the Federal Reserve Act. It was created in 1913 really as a response to the financial panic that happened in 1907, where a lot of banks went bust. And so the Federal Reserve was created really as a tool or a market helper to kind of smooth out those boom and bust economic cycles.
After the Civil War, the US went through several vicious cycles where they’d have four or five years of a boom economy, then an even longer period of some really nasty economic busts. And so the Federal Reserve was created in 1913 to help smooth out some of these economic cycles.
Now, they wrote a formal mission statement, if you want to call it that, in 1977, saying that the ultimate goal of the Fed was to promote stable prices, which most people interpret as controlling inflation, and the secondary goal was to promote maximum, sustainable, economic output—that’s growth in the economy—and promote maximum employment. And that became a very important part of their mission statement in the last week or so.
Brendan: So what is this quantitative easing?
Tom: Well, since the Fed dropped rates to 0 in 2008, as a response to this economic meltdown that we had after the housing bust, but that tool that they have in their toolbox of raising and lowering rates is pretty much useless because rates are at 0, so they can’t lower rates beyond 0. So the way that they can ease or lower rates, is to effectively manufacture a rate cut.
Brendan: Okay. So how do they go about manufacturing something like that?
Tom: Okay. Well, what they’re doing with quantitative easing is instead of just lowering rates, they go into the open market and they actually buy bonds.
So let me ask you a question, Brendan, any time you buy something from someone, what does the seller get?
Brendan: Money, right?
Tom: Right. So when the Fed goes into the open market and they buy bonds, the sellers, the banks, get cash. So what’s really happening is, sometimes you’ll hear people say, “Oh, the Fed’s just printing money.” Well, kind of, because they’re giving money to the bank, but they’re taking back bonds. Sometimes it’s treasury bonds, sometimes it’s mortgage-backed bonds. But the original idea was to get cash into the banks. And so with quantitative easing, the concept was, let’s load up the banks with cash with the plan or the hope that the banks would start making loans. This was the first round of quantitative easing in 2008.
But there was a wrinkle, and it’s a pretty big wrinkle. Since Lehman Brothers collapsed in 2008, the Fed’s been insisting now for the last 4 years that the banks raise their reserve requirements. The reserve requirement is how much money, how much cash the banks keep on hand. So much of the quantitative easing from the last couple of years has just helped the banks meet the capital requirements that they are supposed to have, you know, the money they’re supposed to have on hand. So now, this quantitative easing, they can finally get to the point where banks can start talking about lending at an increased rate to kind of spur economic growth.
Brendan: Okay. So why is this quantitative easing different than previous programs?
Tom: All right, that’s really important to understand. This really was a game-changer, what the Federal Reserve announced last week. In previous quantitative easings, the Federal Reserve announced we’re going to buy X-amount of dollars worth of bonds and it’s going to last over a certain number of months. So everybody knew the size and the scope of how long these quantitative easing programs were going to last.
Now, what the Federal Reserve came out and said last week was, “We are going to buy bonds at a rate $40 billion a month and we are going to continue doing that until unemployment gets under 7%.” There is no real gauge of how long that could be. It could be six months, it could be two years, there’s really no way of knowing how long this quantitative easing program is going to last.
So while some people may say, “Hey, I’ve got a real problem with the Federal Reserve just piling all this money onto the national debt,” or “I’ve got a problem with the Federal Reserve pumping all this cash into the banks and they’re not lending,” the real issue for your investment portfolio is the Fed is going to, has been saying, “We’re going to be keeping interest rates low for a very, very, very long time and that’s going to spur economic activity.” Which is normally good for stocks. It also brings the idea that we may get some inflation and so we see a rise in commodity prices as well.
All of these things are really important to know but they’re not considered investment advice. And if you’re relying on a podcast for investment advice, I want to tell you, you’re making a huge mistake. We strongly urge our listeners to consult with their investment advisor before they make a decision to buy or sell any investment.
And if you don’t have an investment advisor, feel free to get in touch with us at Mullooly Asset Management. We’ll be happy to answer all of your burning questions about investments and any specific questions you have about a certain mutual fund, stock, or other kind of investment.
You can reach us on the web at Mullooly.net, that’s M-u-l-l-o-o-l-y.net, or you can call us at 732-223-9000.
So Brendan, some great questions this week about quantitative easing and we look forward to catching up with everybody next week on the podcast.
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