June 27, 2012

The Federal Reserve will roll out a third round of asset purchases from banks — known as quantitative easing — in September to serve as a floor to keep the economy from waning, Bank Of America Merrill Lynch analysts say.

 

This third round of asset purchases, known as QE3, is the latest arrow the Fed has drawn from its quiver to steer the economy from deflationary decline and higher unemployment rates.

 

The Federal Reserve recently announced it was expanding a $400 billion program that shuffles its Treasury holdings, known as Operation Twist, by another $267 billion.

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Under Operation Twist, the Fed purchases longer-duration Treasury securities while selling an equal amount of shorter-duration Treasury securities with the aim of keeping long-term interest rates low.

 

Quantitative easing, unlike Operation Twist, expands the Fed's balance sheet.

 

The Fed will likely buy $500 billion in mortgage-backed securities to steer the economy away from deflationary pressures on top of other recently announced easing measures.

 

"Our forecast is for $500 billion for QE3 in September concentrated in the mortgage market. This is on top of Operation Twist," says Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch.

 

The Federal Reserve has already rolled out two rounds of quantitative easing since the downturn, known widely as QE1 and QE2, snapping up $1.7 trillion in Treasury instruments held by banks and another $600 billion in mortgage securities with the aim of steering the country away from decline while creating conditions ripe for investment and hiring.

 

This time around, QE3 will serve as a floor to keep the country's economy from stalling as opposed to spurring any time of recovery.

 

"Unfortunately, as the Fed has admitted, every additional round of QE has diminishing returns, especially in terms of feeding into the overall economy. We don't think it will play a very big role the job numbers or GDP," says Michelle Meyer, senior U.S. economist at Bank of America Merrill Lynch.

 

"We think if they were not to do QE, the economy would look weaker," Meyer adds.

 

"The challenge that the Fed has is when the economy slows sufficiently, when the stock market sells off, when the inflation break-even falls, if the Fed does not come forward with the accommodation that they expect, then you see a further weakening in the economy. So the fact that we think that the Fed will satisfy basically what the market expects, and what the economy needs, we won't see a significant change to unemployment."

 

The unemployment rate currently stands at 8.2 percent, according to the Bureau of Labor Statistics May jobs report, which showed the economy created a net 69,000 nonfarm payrolls.

 

Meanwhile, the country is bracing for the end of the year, when Bush-era tax cuts and other tax holidays end at the same time automatic spending cuts kick in, a combination known as a fiscal cliff that could siphon billions out of the economy next year and derail recovery.

 

Fears of such alone can hurt growth, especially with Europe mired in its debt crisis and riddled with uncertainty.

 

"To us it's not necessarily the size of the cliff but the reaction to the cliff, the uncertainty that will filter into business and consumer decisions," Meyer says.

 

The fiscal cliff could shave as much as 4.5 percentage points off GDP though stop-gap measures will likely cut that drag in to around 2 percent, Meyer adds.