US prepares for the next round of QE

The Federal Open Market Committee's (FOMC) forecasts of US inflation and unemployment seem to make a case for additional quantitative easing (QE). The committee estimates the long-run unemployment rate that is compatible with stable inflation to be about 5.5 per cent. Even with all the monetary accommodation currently in place, most of the policymakers still do not expect unemployment to get close to the longer-run 'full employment' rate for the next three years.

And if inflation is stable and unemployment is well above the long-run, non-inflationary rate, a strong argument can be made in favour of additional action to push down unemployment.

The Fed has initiated several easing moves since summer 2011. Last August, the FOMC announced its "anticipation" that the Fed funds rate would stay close to zero until mid-2013. In September, it inaugurated Operation Twist, the sale of USD400 billion of short-term Treasury securities over nine months and the simultaneous purchase of longer-term Treasury securities.

Then, in January 2012, it extended the anticipated period of a near-zero Fed funds rate out until late 2014. A new round of QE may be piled on top of these moves within months of that declaration.

A weak housing market inhibits the economy's overall growth by reducing household wealth, limiting access to credit and imposing significant loan losses on financial institutions.

Operation Twist requires the Open Market Desk to make sales and purchases of Treasury securities on an almost daily basis. Adding another purchase operation at this time could interfere with the smooth functioning of the market for Treasury securities. It thus seems more than likely that the Fed will wait until the current maturity extension programme is finished in June 2012 before launching a new purchase operation.

Waiting until then would also give policymakers more time to assess the effectiveness of their current attempts at monetary stimulus. Monetary policy works with long and variable lags. The ample liquidity and low interest-rate environment that the Fed has created may be slowly but steadily fostering conditions for an increase in demand growth.

If the economy performs better during 2012 than the majority of the FOMC members expect, they can relax a little and let the current maturity expansion programme end without any new asset-purchase initiative to follow it. However, if the economy remains in the doldrums, they can initiate a new asset-purchase programme to put additional downward pressure on longer-term interest rates.

Some of the committee's policymakers have already spoken out on the need for federal government policies that would foster a more rapid recovery in the housing market. To help in that effort, it is becoming increasingly likely that the Fed itself will engage in a new round of QE by purchasing agency mortgage-backed securities (MBS).

The housing market has an effect on the wider US economy that is disproportionate to its size. A weak housing market inhibits the economy's overall growth by reducing household wealth, limiting access to credit and imposing significant loan losses on financial institutions.

Distress in the housing market has also blunted the effectiveness of monetary policy. Low interest rates have not had the usual effect of bolstering housing demand or improving household finances through widespread mortgage refinancing.

Fed officials are concerned that the housing situation may get worse before it gets better. Mortgage arrears are still high. Over time, more and more delinquent mortgages will move to foreclosure, and lenders will come into possession of more and more homes. The New York Federal Reserve estimates that the number of repossessed properties could rise to 1.8 million in 2012 with the same number again in 2013 – up from 1.1 million in 2011.

As more properties are seized by lenders and put into the market for sale, downward pressure on house prices will persist. Indeed, recent data suggest that average house price declines began to accelerate again in late 2011.

The Fed can have an impact on the housing sector by trying to keep mortgage rates low, both to assist in refinancing mortgages and making home purchases more affordable.

In January 2012, Fed chairman Ben Bernanke sent a 'white paper' to the Senate Banking Committee and the House Financial Services Committee, outlining the severe nature of the housing problem and offering an evaluation of various policies that might address the situation. Possible policy approaches included loan modification programmes via refinancing or principal reduction, improving incentives for loan-service companies to modify existing loans, changes to risk fees charged by mortgage agencies and programmes to move foreclosed properties to bulk buyers for rental housing.

In February, the Obama administration announced its own series of housing initiatives. One was aimed at making mortgage refinancing available to 'underwater' borrowers – those whose properties are worth less than their loan – and another was aimed at helping switch foreclosed properties into rental properties more easily.

The Fed can have an impact on the housing sector by trying to keep mortgage rates low, both to assist in refinancing mortgages and making home purchases more affordable. It now holds about USD940 billion in agency debt and agency MBS on its balance sheet, compared with USD1,662 billion in US Treasury securities.

Adding to the MBS portfolio seems feasible. The Fed could try to use its balance sheet to lower average mortgage rates in various ways.

Possibilities include buying more agency MBS outright; buying current low-coupon MBS and selling holdings of higher-coupon MBS to extend the duration of the Fed's mortgage portfolio; and setting a range for mortgage rates and holding that range for a set period to facilitate mortgage refinancing.

It would not be at all surprising to us if, during spring 2012, Fed officials publicly discuss the various approaches they might take to prop up the housing market.

This report must be read with the disclosures, analyst certifications and the disclaimer.