Thursday, 20 September 2012

What is QE3 and why did the share market react so strongly to it?

If you follow the share market at all you will have noticed that there was a major spike towards the end of last week as the US Federal Reserve announced that it would undertake QE3.  This post is a quick background for all those who were wondering why the market spiked so much last week and what the impact of QE3 will be going forward.

QE3 actually stands for a form of unconventional monetary policy known as quantitative easing.  The quantitative easing announced on Thursday last week was the third time the Federal Reserve had announced this policy would be implemented (and hence the 3)

What is Quantitative Easing?

As mentioned above quantitative easing is a form of monetary policy.  Normally when an economy is slowing or inflation is well below central bank target levels, the central bank (or Federal Reserve in this case) will step into the market and reduce interest rates to help stimulate demand in the economy. 

The problem that the US Federal Reserve had was that it had already reduced interest rates to effectively zero which means that they could do nothing further on this front to help stimulate demand in the economy.  Given interest rates can be changed on very short notice the Fed had even tried to extend the period which they were committed to these low interest rates (currently they say they will keep them low out to 2015).  This still did not have the desired result and so interest rates are effectively useless now.

The US Fed then turned to quantitative easing.  The basic idea of quantitative easing is to print money and use that money to buy back US Treasuries and mortgage backed securities to provide liquidity in the market.  The basic hope is that with the excess of capital now in the market that investments will be made in 'real world' assets or on consumption and so stimulate growth and fix the economy.

Why does it involve buying US Treasuries and mortgage backed securities?

Using the money to purchase US Treasuries and mortgage backed securities is a function of the current financial crisis
  • There has been a general 'flight to safety' where money has flowed to those assets deemed most safe in the markets.  If you have a look at the yield on US Treasuries it is clear that this is where a lot of the money has been flowing.  The Fed's aim was to move some of this money out of US Treasuries by buying these bonds back and hopefully people will allocate their funds elsewhere in the market
  • The market for mortgage backed securities is still very weak and people do not want to be buying these assets.  By providing liquidity for these markets it is hoped that funding will return to these markets so and effective borrowing costs for homeowners will come down
Why did the share market react so strongly?

There are several reasons the share market reacted so strongly:
  • It is a pure demand / supply outcome.  If you have billions of dollars flowing into the market which have been created out of thin air then this increases demand for the same supply of stocks thus increasing the general level in the market
  • It provides confidence  in the market.  There are some who believe that this is the first step on the road to recovery.  That the inflow of funds will help right the state of the US economy and that things will return to normal.  I am less confident about this.  Given this is the third time that the US Fed is introducing quantitative easing it suggests that the strategy is not all it is cracked up to be.  There is a downside as well - market participants start to expect this level of involvement from the government and when and if it stops the market will return to 'normal levels'
The outcome from QE3 is far from certain.  Over the last week we have seen the dust settle after the furor created by the announcement and general market sentiment and share prices start to pull back.  Perhaps it will be this round of quantitative easing that works or perhaps the Fed has done nothing more than create inflation through the printing of money.


  1. This comment has been removed by a blog administrator.

    1. I was a little confused by your comment and then noticed that it was worse than spam!

      You ripped off someone else's comment word for word from another blog where there was an active disagreement going on about the merits of QE3.

      For all those interested search for 80% on this blog: