QE3 Isn't Working

 | Feb 12, 2013 | 5:00 PM EST
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The Federal Reserve has a dilemma, which means traders and investors have one, too. The primary goal of monetary policy is to stimulate economic activity, which requires lending and borrowing.

This is where things get tricky, because the Fed actions that can give lenders more confidence and promote lending can also make borrowers less motivated. This is called the paradox of thrift, which I discussed in October following the Fed's announcement of plans to purchase $40 billion worth of agency mortgage-backed securities per month.

Since then, opposing sentiments have arisen in the financial markets. Lenders and bond buyers have not committed to the residential mortgage market as the Fed had intended. The prevailing concern among market participants has been, and continues to be, that the Fed will withdraw support for the mortgage-backed securities market unexpectedly, perhaps much sooner than the Fed has implied. If that happens, the value of existing MBS would be negatively affected. As a result, lenders have not aggressively pursued making new loans and mortgage spreads have remained stubbornly high. This is not what the Fed wants, but the Fed has not sought to dissuade markets of this belief, either.

One reason the Fed has not tried more forcefully to persuade the markets of their commitment to support the residential-mortgage market is to counteract consumers' sanguine attitude about the cost of capital. Consumers are becoming accustomed to low borrowing costs and believe the trend will continue, thus they are not moving to access the low rates with the urgency the Fed intended. Lenders are worried the rates are going to go up and they are hesitant to lend as a result. Meanwhile, consumers are not worried about this at all and are in no hurry to borrow.

This is a quandary for the Fed and a potentially serious situation for the banking industry.

Ten-year Treasury yields and 30-year fixed mortgage rates are both about 25 basis points higher today than they were when the Fed made its announcement in September. They are also higher than they were when the Fed announced in December its intention to buy $45 billion worth of long-term Treasuries per month. And mortgage spreads have not declined. The September announcement was supposed to cause mortgage rates to decline, lenders to lend, borrowers to borrow and mortgage-backed-securities buyers to buy. So far, none of that has occurred to the extent that the Fed's program could be considered successful.

Even though the intended effect has not been achieved, Federal Open Market Committee members have indicated a hesitancy to continue the mortgage purchase program, as reflected in the minutes of December's meeting. That doesn't mean that they are going to, though.

The bottom line is that a failure to show results from policy moves over the past four months indicates that the Fed will do something else. It could buy even more MBS to force mortgage rates down further, or it could do the exact opposite, allowing mortgage rates to rise. The first case targets lenders, the second targets consumers. Either way, it's likely that the Fed will have to do something different to effect a change in the status quo.

To see Part 2 of this article, please click here.

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