What to Expect from the Federal Reserve’s Next Round of Quantitative Easing, QE2

By: Money_Morning

Jon D. Markman writes: The U.S. Federal Reserve today (Wednesday) is all but certain to announce a second round of quantitative easing - "QE2."

Most analysts believe the Fed will pledge to buy another $500 billion in U.S. Treasuries, but I think it will go even further. My expectation is that $500 billion in Treasury purchases over six months will be just a first step, and that the full amount contemplated - as much as $2 trillion - is much larger than consensus.

This view is based on an analysis by Goldman Sachs Group Inc. (NYSE: GS) chief domestic economist Jan Hatzius that suggests current interest rates, at 0% to 0.25%, are 700 basis points too high. In plain English, the Goldman analysis suggests that interest rates would have to be -7% to achieve the Fed's goals.

To get to that level, the government is using three tools:

•Fiscal policy, such as tax cuts and infrastructure spending.
•Asset purchases - like buying Treasuries.
•And commitment language - stating that the program will continue for "an extended period."
Each of these levers is assigned a number that corresponds with its contribution to eliminating this "policy gap" and getting to -7%.

Goldman's view is that an additional asset purchase of at least $2 trillion will be necessary to close the policy gap.

Goldman expects the process - which the Fed itself calls "large-scale asset purchases," or LSAPs, rather than quantitative easing - to start with $500 billion over six months. There's also a chance that the Fed will state a monthly purchase goal of around $100 billion to be maintained until its outlook for inflation and employment improve.

Both bulls and bears can agree that a federal funds rate of -1% is very easy. Where they differ, though, is that bulls believe the Fed thinks "very easy" policy is inadequate and that policy must be "massively easy" to facilitate growth and job creation, and to fill the output gap and lift inflation to the desired level.

Because fiscal policy is doing its part and commitment language is doing its part, the Fed does not have to cover the gap to -7% with LSAPs alone. But more LSAPs are still needed.

Goldman figures that the first phase of quantitative easing, or QE1, managed to cut interest rates by 80 basis points per $1 trillion in purchases. It figures that the "extended period" language has provided another 30-point boost. After some additional calculations, it figures another $1 trillion in LSAPs would provide another 75-point cut in the funds rate. That's less than the 100 to 150 basis point range recently cited by the Federal Reserve Bank of New York, as well as the 130 basis points estimated by the Federal Reserve Bank of San Francisco.

So how much more should the Fed do?

Goldman figures that non-LSAP measures have cut the policy gap from 700 basis points to 300 basis points. Of the remainder, QE1 was worth 130 basis points and the existing commitment language is worth 30 basis points. Therefore, the Federal Reserve would have to buy an additional $4 trillion in assets to close the rest of the gap.

Goldman acknowledges that the Fed is unlikely to go that far unless the economy performs much worse than forecast. Hatzius says there also are many "tail risks" associated with the program such as the possibility of large mark-to-market losses on the Fed's investment, which would be embarrassing. And more large- scale purchases may cause the public to expect much higher inflation in the future, which would depress price/earnings multiples on stocks, among other issues.

The bottom line: Figure the Fed is willing to go to $2 trillion, or even $4 trillion if necessary. If this is the case, then stocks have in no way discounted the full effect of the next round of quantitative easing. That leaves the bullish case for 2011 wide open.

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Source : http://moneymorning.com/2010/11/03/...

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