The Fed statement just released indicates that the central bank intends to purchase a net total of $600bn of longer term Treasury securities between now and the end of 2011 Q2, at a pace of around $75bn per month. This was almost exactly in line with what the market had been led to expect, so there was no surprise in the extent and timing of QE2. However, there was no further softening in the Fed’s statement that interest rates are likely to remain exceptionally low for an “extended period”, which may have disappointed some observers who were looking for this language to shift in a dovish direction. Overall, the markets initial reaction was a shrug of acceptance that the Fed has done just about what it told us it would do, but certainly no more.
So what has the Fed actually done? The $600bn of net Treasury purchases, which will be spread fairly evenly across the yield curve, will increase the size of the Fed’s balance sheet by around 25 per cent over the next 8 months. 
The monetary base in the US will rise by about 30 per cent over the same period. By the yardsticks that would be applied in any normal period, these would be considered to be extraordinary developments. But in the current environment, with short-term interest rates at the zero bound, and the economy in a liquidity trap, the effects of this monetary injection on the economy may be rather small.
The second round of QE, as announced on Wednesday, is only about one-third the size of the first round. QE1 is usually estimated to have reduced long-term interest rates by about 0.5-0.75 per cent, and to have had almost no effect on broader monetary aggregates like M2. On a pro rata basis, the impact of QE2 would therefore be to reduce long-term rates by about 0.25 per cent, and to boost the growth of M2 and bank credit by a percent or two. These are fairly trivial figures, so what is all the fuss about?
Clearly, the fuss is mostly about asset prices. The announcement of QE2 has broken new ground not so much in its initial quantum, but in the fact that the Fed is willing to embark on this unconventional programme in the absence of any obvious financial or economic emergency. In fact, it has been willing to do so in the face of recent economic data which are definitely not indicative of a double dip in the economy. The ISM figures released in the past few days suggest that the economy may re-accelerate in the current quarter, despite the Fed’s insistence that the recovery remains disappointingly slow.
And, importantly, the Fed said that it would be willing to adjust the pace and overall size of its asset purchases in the light of future economic circumstances, which may encourage the markets to believe that there is a “Bernanke put” underlying the equity market. Almost certainly, the Fed is happy to see rises in equity prices and declines in the dollar, despite warnings that this stance may induce bubbles to develop in the US and overseas.
It is interesting to review market behaviour
since Mr Bernanke’s speech at Jackson Hole on 27 August, which indicated that QE2 might be around the corner. Bond yields have hardly moved since that speech, but inflation expectations within the TIPS market have risen by over 0.5 per cent. And commodity and equity prices have risen sharply, by 16 per cent and 11 per cent respectively. These developments are all consistent with a belief that the Fed is intent on reflating the US economy, and that it will succeed in doing so.
Probably the oldest piece of advice in asset management is “don’t fight the Fed”. It usually works. If the economy grows moderately in coming months, while the Fed steadily injects money into the financial system, risk assets could benefit further.
(A more complete assessment of the pros and cons of QE2 appeared in this earlier blog.)
