IHS Global Insight Perspective

Significance: The markets have been speculating on when the Federal Reserve would start quantitative easing for many weeks, so the announcement came as no real surprise.

Implications: When added to the existing programme for the reinvestment of mortgage principal repayments, the Fed's balance sheet could expand by close to US$900 billion. This is still not as high as some had speculated.

Outlook: The Fed's activities appear to be paying off with various pieces of good economic news of late.

Fed Nudges the Economy Along

At its latest scheduled meeting, the U.S. Federal Open Market Committee (FOMC) elected to leave the target range for federal funds unchanged at its historic low of 0.0% to 0.25%. It re-asserted the "EE phrase" that "economic conditions [are] likely to warrant exceptionally low rates for an extended period". The FOMC will also continue to reinvest mortgage principal repayments. The economic recovery has been moving at a very slow pace, so the FOMC decided to expand its holding of securities in order to speed up the pace of economic recovery. It plans to purchase an additional US$600 billion in long-term Treasury securities by the end of the second quarter of 2011 at a pace of about US$75 billion per month. The FOMC will review the programme on an ongoing basis and adjust as needed based on the performance of the economy and prices. Kansas City's Federal Reserve chief, Thomas Hoenig, cast a dissenting vote for the seventh meeting in a row, stating that the "risks of additional securities purchases outweighed the benefits".

The FOMC flagged familiar risks to the outlook:

Household spending is constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

Commercial construction remains weak and businesses remain reluctant to add to payrolls.

Housing starts remain at a depressed level.

The high level of unemployment and relatively low level of underlying inflation are inconsistent with the Fed's dual mandate of fostering maximum employment and price stability.

Outlook and Implications

By pushing the button on quantitative easing, the FOMC basically delivered what the markets had expected, and speculated about, for many weeks. There were no big surprises here. When added to the existing programme for the reinvestment of mortgage principal repayments, the Fed's balance sheet could expand by close to US$900 billion. The most problematic issue that the Fed must deal with is the management of market expectations. Markets had already discounted the programme weeks ago, but there had been considerable speculation about the size of the programme, including some wild estimates as high as US$2 trillion. The 10-year bond yield dropped sharply in early October, to near 2.4%, just in advance of Bernanke's definitive speech on 15 October. As markets recalibrated expectations, the 10-year bond yield cycled back up to near 2.6%. The Fed's programme was broadly in line with expectations, so the bond market reaction was relatively muted when the press release hit the markets. The stock market reaction was also muted.

The good news is that mortgage rates have tracked downwards to near 4.25%, and the stock market has risen not only in response to recent positive earnings reports, but in anticipation of some positive benefits to the economy from the Fed's recent actions. From a portfolio balance perspective, the US$600-billion programme announced by the Fed on 3 November will devour roughly half of the Treasury's US$1.3-trillion funding requirement for fiscal 2011. Thus, barring a sudden and unexpected upturn in economic activity, IHS Global Insight expects long-term bond yields will probably ease down over the next several weeks to land near 2.5% in early 2011. Mortgage rates, therefore, are expected to remain at historically low levels for the next several months, and that will be a support to the housing market.

More good news is that the Fed's actions over the past several months are already starting to have a positive impact on economic activity, with the ISM indicators for both manufacturing and services perking up in October, and recent indicators also pointing to slightly stronger private-sector job growth as we enter the fourth quarter. The economy is slowing digging itself out of a deep hole. The Fed is making the right moves here to nudge the pace of digging up a little.