As detailed earlier in the month, the Federal Reserve announced more stimulus, otherwise known as QE4, at its recent meeting.

Lots of the discussion thus far has focused on whether or not QE will happen and not on the purpose of QE.

What we discuss below is a good example of economists discussing the probability of QE rather than why QE is necessary or what it will accomplish.

So, what is QE supposed to do?  Bernanke told us in his speech over the summer in Jackson Hole:

This is not the first time the Federal Reserve has laid out this argument.  In a November 4, 2010 Washington Post op-ed, the day after QE2 was approved, Ben Bernanke defended their actions with the following passage:

And in January 2011 Bernanke said:

To sum it all up:

• The Federal Reserve buys Treasury bonds in order to push down interest rates, making them an unattractive investment (last shown here, page 6) .

• Investors respond by moving out the risk curve and buying assets like corporate bonds and stocks, pushing them higher.  The Federal Reserve believes this happens via the portfolio balance theory.

• But according to the Federal Reserve, moving out the risk curve does not include buying agricultural or crude oil futures, so do not blame them for higher food or gasoline prices.

• Higher asset prices create a wealth effect, which increases spending and confidence and improves the economy. The Federal Reserve believes this has helped create 2 million jobs.

We agree with half of what is written above.

• QE does produce lower interest rates, or at least the belief that rates are too low.  This then pushes investors out the risk curve which is why stocks have such an immediate and positive reaction whenever QE is speculated.

• The Federal Reserve is playing politics in regards to the effect of QE on commodity prices.  There is no reason to believe the risk curve ends at low-rated stocks.  How much QE affects food and gasoline prices can be debated, but to argue there is no effect at all, and will never be an effect under any scenario, merely because the Federal Reserve does not want to answer for these higher prices, is just wrong.

• The argument that higher asset prices produce a wealth effect is only partially correct.  Two conditions must be met for a wealth effect to ensue.  Net worth must reach a new high and it must be perceived to be permanent.  This is why housing produced such a powerful wealth effect before 2006.  Home prices always went up and their gains were perceived to be permanent.  Currently we have a retracement of losses and a widespread distrust of financial markets.  These conditions will not produce any wealth effect and we believe they have not.

QE is great for Wall Street as it produces more volatility (brokers like this), higher stocks prices (fund managers like this) and draws lots of attention (analysts like this).  It is not good for Main Street because it does not create wealth.  QE’s effects are not perceived to be permanent, so it does not lead to higher GDP or job growth.

What Will The Federal Reserve Do?

In Septmber we noted that the median expectation in a survey of primary dealers calls for $500 billion of additional purchases heavily tilted toward mortgage-backed securities.   If the purpose of QE is to push stock prices higher, then the Federal Reserve has to deliver at least $500 billion in purchases.  Otherwise it will disappoint risk markets.

Right now, if we have to guess, we believe the Federal Reserve will announce purchases of less than $500 billion. In January the Federal Reserve adopted an inflation target of 2.0%.  As we detailed in a conference call last month (transcript, handout, audio), inflation expectations are running well above this target.  One measure of inflation expectations, the 10-year TIPS inflation breakeven rate, is shown below.  Further, in April, when Bernanke was asked if he would adopt a suggestion from Paul Krugman to expand the target to 3%, he flatly rejected the idea (explained here).

The hawks will argue expected inflation is too high to add more stimulus, an argument which will carry some weight.  The compromise will be a program of less than $500 billion in purchases which will disappoint the markets.

Click to enlarge:

Source: Arbor Research