U.S. Fed announces Quantitative Easing (QE3) tapering

James Ryan Jonas

The Federal Open Market Committee (FOMC) of the U.S. Federal Reserve announced yesterday, June 19, that if the U.S. economy continues to improve, it will start winding down its asset-buying program and may completely end it by mid-year of 2014.

The news sent stock markets in the United States down by more than 1 percent, with the Dow Jones industrial average (DJIA) closing 205.96 points lower, or 1.34%, at 15,112.27.

The Standard & Poor’s 500 Index (S&P 500), meanwhile, closed 1.39% lower at 1,628.92, while the Nasdaq Composite Index was down 1.12% at 3,443.20.

What is Quantitative Easing 3 (QE3)?

Federal Reserve chairman Ben Bernanke hinted during the FOMC press conference yesterday that the end of QE3 may be coming to a close. He emphasized, however, that this will only happen if the recovery of the U.S. economy continues.

“If you draw the conclusion that our policies — that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy,” Bernanke said during the conference. “If the economy does not improve along the lines that we expect, we will provide additional support.”

The Fed’s Quantitative Easing (QE 3) program is a monetary policy used by central banks to stimulate an economy when standard monetary policies have become ineffective.

Typical monetary policy of central banks includes purchasing short-term government bonds to drive interest rates lower, with the hopes of stimulating the economy. However, when interest rates are at near-zero levels, as in the case of the United States, this monetary policy is ineffective because interest rates cannot be driven lower further.

In such a case, central banks would buy a pre-determined amount of bonds or other assets from the open market, with the goal of increasing the money supply instead of decreasing the interest rate.

Round 3 of QE

The third round of quantitative easing, hence the term QE3, started in September 2012, with the Fed announcing it is buying $40 billion every month of mortgage-backed securities. In December 2012, the FOMC announced it is increasing the monthly bond-buying purchases from $40 billion to $85 billion.

This stimulus provided by the Fed brought additional liquidity to the market which helped stabilize the U.S. economy in the first months of 2013. It also propelled investments to other parts of the world, including the Philippines which is said to have benefited from the influx of foreign investments to the Philippine stock market in the past months. (See 1st Quarter 2013 Performance of Philippine Stocks)

Improving GDP, unemployment and inflation rates

The decision to taper the QE3 program is said to be caused by a recovering U.S. economy. Fed officials noted that America’s unemployment and inflation rates are within expectations and are showing signs of improvement.

The jobless rate in 2014 is estimated to be 7.2% to 7.3%, compared with 7.3% to 7.5% earlier forecasted in March. In 2014, the Fed expects the unemployment rate to fall further to 6.5% to 6.8%.

Core inflation, meanwhile, is expected to slowly rise — also a sign of an improving economy. Core inflation, which excludes in its basket items with volatile prices such as food and energy, is estimated to rise to 1.5% to 1.8% in 2014 and 1.7% to 2.0% in 2015.

The Fed also raised its expectations for the growth of the U.S. Gross Domestic Product (GDP) next year, from 2.9% to 3.4% in earlier forecasts to 3.0% to 3.5%.

Stocks, bond prices drop as markets react

Stock and bond markets slumped following the Fed’s announcement of the winding down of the QE3 stimulus. The three major stock indices in the U.S. — the Dow Jones industrial average, S&P 500, and NASDAQ Composite all dropped by more than 1% after the news came out.

Hardest hit were bonds whose prices dropped, sending bond yields to new highs. The yield on 10-year Treasury note rose 2.36%, the highest since March 2012, from 2.19% a day before.

On June 20, Philippine stocks were down 2.25%, losing 146 points at the opening bell.

Read these other interesting and useful articles:

James Ryan Jonas teaches business management, investments, and entrepreneurship at the University of the Philippines (UP). He is also the Executive Director of UP Provident Fund Inc., managing and investing P3.2 Billion ($56.4 Million) worth of retirement funds on behalf of thousands of UP employees.