Fed announces additional monetary stimulus

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(MoneyWatch) The Federal Reserve's announcement today that is launching a thirdround of quantitative easing validated widely held expectations that the central bank would provide more monetary stimulus in an effort to speed the economic recovery.

The Fed said it will purchase $40 billion a month in mortgage-backed securities and extended its guidance on interest rates. Rates will stay low through mid 2015 instead of 2014, the bank said. The additional Fed easing, along with its intention to continue reinvesting the proceeds from principal payments from its holdings of financial assets, will increase its inventory of securities by approximately $85 billion each month through the end of the year. These actions, which are more aggressive than many analysts expected, "should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative," according to a Fed statement.

The Fed's decision to provide further accommodation breaks the gridlock within the Fed's monetary policy committee resulting from disagreement about the costs and benefits of further action. One faction has argued that structural impediments in the economy limit the ability of the Fed to stimulate employment. This group believes the main consequence of further easing will be inflation, and hence the costs of further easing are larger than the benefits. In fact, some within this group would prefer to reverse existing policy. The other faction believes the inflation fears are overblown, and there is plenty the Fed can and should do to help with the unemployment problem.

Fed to spend $40B a month on bond purchases
How does "quantitative easing" work?
Full text of the Federal Reserve's statement

There are also several centrist members who believe the potential for inflation and the benefit of further action are fairly close, and until now the scale had tipped against further action.

Several things changed their minds. First, the main driving force behind the policy change was the recent Labor Department report showing that thelabor market continues to stagnate. But a second factor was also important. At the recent annual Federal Reserve conference in Jackson Hole, Wyoming, the former chairman of George Bush's Council of Economic Advisers, Ed Lazear of Stanford University, presented evidence that the unemployment problem is not structural, as many who object to more stimulus contend. This likely led some members of the Fed to reevaluate the benefits of further easing, and tipped the scale in the other direction. Finally, recent data has not justified the worries about inflation. In fact, many measures show inflation running below the Fed's target level.

The policy the Fed announced today is unusual in that it is an open-ended purchase of securities. The Fed did not announce a total dollar value as it has in the past, but instead committed to continue buying assets until economic conditions change. That means it will continue the securities purchases until unemployment falls "substantially" or inflation begins to increase to worrisome levels.

The extension of the forward guidance on interest rates to 2015 is also unusual, but both of these can also be explained by the recent conference in Jackson Hole. At that conference, Michael Woodford, a highly respected monetary economist, delivered a paper showing that the Fed has the most impact on the economy when it credibly commits to future actions. Thus, according to Woodford, it is not the quantitative easing itself that helps the economy (i.e. how many assets the Fed holds), but rather the commitment to continue purchasing assets until the unemployment rate improves substantially that matters. This is a form of forward guidance, and it complements the forward guidance on interest rates that the Fed has issued in the past and extended today.

Even with the policy commitments issued today and the actual actions the Fed will take, there is some question about how effective the Fed will be at stimulating the economy. The policies work mainly through lowering long-term interest rates and elevating stock market values. But there is not much room for long-term interest rates to fall, and the stimulative effects of higher stock values aren't that large. In addition, some analysts worry that this will make it far less likely that Congress will initiate tax cuts, additional spending, or direct job-creation measures, though political gridlock likely eliminates that possibility in any case.

Not everyone, however, agrees that the Fed is relatively powerless, and with fiscal policy off the table, inflation worries very low and the unemployment problem very large, the Fed decided that more action was justified. It may not be able to completely fix our economic problems, but it does believe it can help.

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