QEIII: Would Asset Prices Rise as Much as They Did Under QEII?

The Federal Reserve might soon announce another round of quantitative easing. Reports vary as to when the central bank will initiate the new plan, but many reports seem to be pointing to an announcement in August. The previous round, known as QE2, had a buffering effect on asset prices. The coming round is expected to have a similar effect.

The head of US interest rate strategy at UBS (NYSE:UBS) today said that a third round worth $600 billion in asset buys would be both practical and defensible by the Fed. That would represent a buy of $250 billion in mortgage backed securities and $350 billion in Treasury bills.

The previous round of easing was worth the same sum and precipitated a huge political backlash for the Fed. Whether this round will be more defensible against those same attacks will have to be seen after an actual announcement, but it is likely to be a big political issue if it comes just months before a presidential election.

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QEIII: Would Asset Prices Rise as Much as They Did Under QEII?

Part of the reasoning behind the application of quantitative easing is the desire to stimulate the economy by encouraging investment in riskier asset classes.

The buying of mortgage backed securities is a direct move to improve the current housing market and help it in its fledgling recovery. Whether or not the Treasury bill purchase will have the effect it is hoped to have is still up in the air.

The effectiveness of the last round of quantitative easing is heavily debated. There certainly was a rise in general asset prices during the period but many claim that had little to do with the Federal Reserve’s strategy. The next round might have the same effect but the situation is very different now.

The main thing that is different now from when the second round started is the sheer amount of Treasuries the Fed is now holding. A third round of easing could boost that number up to around 50% of all outstanding bills. That could lead to serious distortions in the liquidity of the Treasuries market.

The Fed has some serious issues to consider before unleashing a new round of quantitative easing on the US economy. The temptation to do it is there because of the massive lack of anything else the institution can do. We’ll see later this year, and into 2013, if the program is launched and what effect it will have on asset prices.