Fed Announces $600 Billion QE2; Holds Rates Steady

One day after the midterm elections handed control of the U.S. House back to the Republicans, the Federal Reserve's policy makers agreed Wednesday to keep interest rates at historic lows and to maintain its policy of reinvesting principal payments from mortgage bonds and other debt into Treasuries.

The Federal Open Market Committee (FOMC) voted to buy $600 billion of longer-term Treasury securities by the end of second-quarter 2011 and to maintain the target range for the federal funds rate at zero to 0.25%. With inflation rates too low for comfort, the Treasury debt purchase program’s objective is to inject enough liquidity into the economy to get it moving at a faster rate.

“To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities,” the FOMC announced in a statement. “The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.”

For advisors and investment managers, the FOMC’s decision has left them wondering whether the Fed’s continued printing of money via debt purchases—because it can’t set interest rates any lower—will have the intended effect of setting the U.S. economy on course by encouraging job creation and business investment.

David Kelly, chief market strategist at J.P. Morgan Funds, was skeptical. He noted

that the economy had already showed signs of improvement in 2010, and that both stock prices and interest rates are likely to trend up anyway in the next year. The bigger question, Kelly said, is the uncertainty that the FOMC’s move will create.

“This economy is not suffering from a lack of liquidity,” Kelly said. “There is not a single home-buyer or business-person in America who’s hesitating to buy something because interest rates are just too high. Attempts to hold interest rates at even lower levels don’t really have much impact on the economy. I do think that the wording of the Fed’s statement today leaves a good deal of further uncertainty.”

The Fed’s purchases of securities over the next eight months will exceed what the total federal deficit will be over that period, Kelly asserted.

“If we’re running the federal government on the Federal Reserve’s credit card for the next eight months, what happens when the Fed takes its credit card away?" Kelly said. The problem, Kelly said, is that "QE2 sets up either the possibility of QE3, because they won’t want the economy to go cold turkey, or else a pretty sharp reaction in the bond market when people realize that this is the last of the help from the Federal Reserve,” he said.

Looking at investors’ portfolio construction in light of the FOMC’s decision, Kelly advised going long stocks and short bonds.