Paging Mr. Bernanke: QE3 Is Too Small

I was a bit over-enthusiastic in my positive reaction to the announcement of QE3+. I was excited by the fact that the Fed was finally targeting an output (employment) instead of an input, and that no limit was set for the amount of expansion required to achieve the target.

As I have run the numbers, however, my enthusiasm has diminished. This is because, aside from the fact that the program has not yet started, the programmed pace of expansion is too low. While there is no ultimate limit on the amount of MBS purchased, the amount to be purchased each month is just too small to get things going.

I say this because QE3 is much smaller than QE1 or QE2. This is true in both an absolute and a relative sense:
QE1 lasted for about six months from the fall of 2008 until the spring of 2009. The Fed bought about $1 trillion in bonds, growing its balance sheet from $800 billion to about $1.8 trillion, an increase of 125%. That was huge.
QE2 lasted for about six months from late 2010 until mid-2011. The Fed bought about $700 billion of bonds, growing its balance sheet from $2 trillion to $2.7 trillion, an increase of 35%, much smaller than QE1.

QE3 is supposed to last until the Fed’s definition of “full employment" is achieved. However, by pacing the expansion at $40 billion per month, even a one-year program will not be big enough. At $40B/mo. for one year, QE3 would be a $500 billion program, for an increase of only 17%. That just isn’t going to cut it.

There should be no limit on the amount of monthly bond-buying, and the program should be front-end loaded with purchases of at least $200B/mo. which is closer to the pace of QE1. There is little risk of overshooting the employment target or of kindling excessive inflationary expectations.

The Fed left open the possibility of a faster pace of expansion:
"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases."

That suggests to me that the program could be expanded next year. So far, the Fed’s buying program is in arrears, as its MBS portfolio has been shrinking instead of growing. The FOMC pledged to buy $37B in MBS by Oct.11th, and to continue to reinvest proceeds from its existing portfolio. The portfolio stood at $844B at the time of the announcement, which suggests that by Thursday the portfolio should be $881B. That would require the Fed to buy $46B of MBS this week, which isn’t likely. So they will have to work a little harder for the rest of the month.

The Fed owes us a report on Thursday or Friday of this week:
“In order to ensure the transparency of its MBS transactions, the New York Fed will publish historical operational results at the end of each monthly period  [beginnning Oct. 11th]. Operational results will include agency MBS transactions associated with both the additional asset purchases announced by the FOMC on September 13, 2012, and purchases related to the reinvestment of principal payments from agency debt and agency MBS in agency MBS.”

So it won’t belong before we know what the story is with the delay in implementing QE3 and what they plan to do about it. It will take a few months before the Fed will be able to judge the efficacy of the program. I would add that, should anything bad happen between now and then (Greek default, stock market crash), Bernanke will undoubtedly hit the accelerator.