At a recent real estate roundtable, the discussion turned to the Federal Reserve’s mid-September announcement of a third round of quantitative easing, better known as QE3, and its likely impact on commercial real estate markets.
QE3 involves the Fed’s commitment to buy $40 billion of residential mortgage-backed securities monthly for the foreseeable future, to reduce long-term interest rates generally — and specifically in MBS markets — and also to stimulate job creation and economic recovery. “Operation Twist” is a Fed program designed to lengthen the average maturity of the Fed’s investment portfolio of U.S. Treasury securities, essentially by selling shorter-term Treasurys — putting slight upward pressure on short-term interest rates — and reinvesting the proceeds in longer-term Treasury securities, thereby adding downward pressure on longer-term interest rates on Treasurys and other securities considered to be good alternatives to Treasurys.
Historically, the Fed tried hard to avoid implementing either expansionary or restrictive monetary policies in the months prior to a presidential election to avoid the appearance of political partisanship. That QE3 is being implemented speaks volumes regarding the intractability of global economic problems and how long the Fed foresees the problems to continue. At the same time, “Operation Twist” is an ongoing program and during the second half of 2012 is expected to amount to approximately $45 billion per month of transactions designed to “twist” the interest rate yield curve by putting slight upward pressure on shorter-term rates and downward pressure on longer-term rates.
The combined $85 billion of Federal Reserve monthly purchases of longer-term Treasurys and MBS for at least the second half of 2012 is a huge number in an absolute sense. It is even a meaningful amount relative to total Treasury and MBS markets, where total securities outstanding are measured in the trillions of dollars. The Fed recently indicated its intention to keep interest rates at exceptionally low levels until mid-2015 to facilitate job and economic growth, and these twin policies —Operation Twist and QE3 — are the horses they are riding.
One relevant question, therefore, is whether the combined $85 billion of longer-term Treasury securities and MBS purchases will achieve their stated goals. A second question is simply why or why not will these initiatives perform as hoped? My expectation is that QE3 and Operation Twist will be useful in preventing a further deterioration in the United States and in global markets. However, by themselves, these policies are not capable of assuring the job and income growth, consumer and business spending, and long-term investments in such things as R&D and infrastructure essential to a strong economic recovery, even though financial markets are fully accommodative. Here's why.
If QE3 and Operation Twist are the horses the Fed is riding, one issue is that there are few if any other horses in the Fed’s stable should these two become exhausted, which is likely, before the race to recovery is won. Further, as in thoroughbred racing, in which occasionally two or more horses are “paired” for wagering purposes, to achieve its goals, the Fed’s policies must rely upon the cooperation of three or more horses with which they are paired: consumers, businesses and government entities, all with the power to spend and invest and save. In effect, these horses make up a team hitched together. All must pull together for the team to win the race.
Unfortunately, there is truth to the adage that you can bring a horse to water, but you can’t make it drink. To that I’d add that even if you bring the water to the horse, you still can’t make it drink, no matter how thirsty it may be.
Economists refer to this situation as a “liquidity trap” because if consumers, businesses and government entities are sufficiently uncertain of their economic futures, they will hesitate to spend and invest, preferring to save their liquidity instead and thereby frustrating public policies that are dedicated to job and income growth and economic recovery.
I am not implying an “all or nothing” situation. Spending and investing are occurring, but not at a size or pace sufficient to stimulate a strong recovery. Excess liquidity continues to be absorbed into savings and debt reduction, which helps to set the stage for future economic expansion while delaying its onset. Despite the $85 billion of monthly investments by the Fed in longer-term Treasurys and MBS, if consumers, businesses and government entities do not respond by increasing their spending and investing, the Fed ends up pushing on a string and going nowhere in the short term.
Two additional ingredients essential to economic recovery are lending by commercial banks in particular, and borrowing by consumers, business and government entities. Some lending is occurring, of course, but not enough to encourage an acceleration of the economic recovery. Banks undoubtedly are remaining more liquid than they need to be, even as they try to expand lending. The flip side, of course, is that the demand for loans by commercial bank customers remains relatively anemic.
There are many reasons why banks are not lending enough and their customers are not borrowing enough to generate a strong recovery. Reasons include banks’ tougher underwriting requirements; customers’ reduced collateral values; deteriorating credit quality among borrowers; rigorous regulatory oversight; increasing uncertainty and costs associated with the Dodd-Frank legislation; the troubled future of Medicare and Social Security; cuts in the social safety net and services at all levels of government; and pension and related municipal budget crises across the United States. Also, members of Congress collectively are held in low esteem and do not inspire confidence in America’s future, even though voters generally approve of their own members of the House and Senate.
The upcoming election offers clear choices between socioeconomic philosophies and policies, but until the results are in, their disparity adds to uncertainty rather than reducing it — not to mention economic and financial chaos in Europe, war in the Middle East and the threat of a nuclear holocaust, which all cast a dark pall over global economic recovery, hope and optimism.
There is no doubt in my mind Federal Reserve officials are frustrated that $85 billion of QE3 and Operation Twist funds flowing monthly into longer-term capital markets are not having their intended effects. Unfortunately, as a nation blending into a global economy we are learning painfully that being a superpower does not give the United States the strength it once did. So too, as the lender of last resort, the Federal Reserve no longer has the tools or the clout to, almost single-handedly, control financial markets and economic activity in the United States and across the globe.
On a more positive note: It is important to keep in mind that the Federal Reserve does not have to sell off the securities portfolio it has accumulated and continues to increase. It has an unlimited checkbook and seemingly a mandate from the Fed’s Open Market Committee to keep the checkbook open. Unlike the political and public pressure for the administration to sell its equity stakes in bailed-out businesses, there is no parallel pressure on the Fed to sell its investments. Perhaps several years from today, when the Fed wants to soak up some of the liquidity currently flooding long-term markets in 2012, it will begin to sell longer-term securities to raise interest rates and to temper the inflation whose seeds are being sown as I write.