What Would QE3 Bring?

With the American economy seemingly stalled again, the Federal Reserve is now debating whether to undertake a third round of quantitative easing. The Fed Open Market Committee is scheduled to meet next week, with Chairman Ben Bernanke likely to announce at the end the renewal of QE. The strategy involves purchasing huge amounts of Treasury bills and storing them in the Fed’s coffers, which has the effect of pumping billions of dollars back into the economy.

While this is intended to have effects on far more than the stock market, there is no doubt that the impact on Wall Street is enormous. The first two rounds of QE lasted from March 2009 through March 2010, and then again from November 2010 through June 2011. There has been some careful academic research devoted to these two rounds of QE, and they can help tell us what might happen to the markets if we do indeed embark on QE3.

On November 25, 2008, the Fed announced a sort of precursor to the quantitative easing program, involving purchasing direct obligations held by Fannie Mae, Freddie Mac and Federal Home Loan Banks, in amounts expected to reach up to $500 billion. This was two months after Lehman Brothers suddenly went bankrupt, and the entire banking sector seemed to be melting down. Whatever the influence of the Fed’s action was, the stock market crashed right along with everything else. The already beaten-down Standard & Poor’s 500 dropped from 857 on November 25, 2008, to 677 by March 9, 2009, losing 21 percent of its value in just over three months.

With the markets in crisis, and deflationary fears starting to spread, the Fed decided it needed to embark on something that would have a more direct effect on the economy. The markets bottomed out on March 9, 2009, and on March 18, the Fed announced that it was buying up an additional $750 billion of agency mortgage-backed securities, bringing its total to up to $1.25 trillion for the year, and more importantly, that it was purchasing up to $300 billion of longer-term Treasury securities over the next six months. If the first purchases were intended to shore up the housing market, this one was intended to help all private credit markets.

It’s worth pointing out that quantitative easing wasn’t the only stimulative program happening around this time. President Obama signed his stimulus package into law on February 17, injecting around $800 billion directly into the American economy. And the bottom for the markets was actually nine days prior to the Fed’s first wholesale purchase of Treasurys.

In any event, though, the markets responded quickly to these actions. By the end of the month, the S&P was up 18 percent from its March 9 low. After continuing for a year, the QE program reached its scheduled conclusion at the end of March 2010, by which time the S&P had risen nearly 73 percent from its trough position a year earlier.

And the market continued to rise, at least for a while. April saw the S&P creep upward about another 1.5 percent. But the rally stalled out over the summer, and fears of deflation began to reappear. The consumer price index held steady at just over 1 percent for much of the year.

By the end of August, Fed chairman Ben Bernanke had announced that the Fed Open Market Committee was prepared to take further steps, including “additional purchases of longer-term securities,” to help with the nation’s economy. At the beginning of November, the Fed formally announced that it was purchasing another $600 billion worth of long-term Treasury notes.