The Fed is not out of bullets (why QE3 will work)

by pdxblake

Paul Krugman offers an explanation on how QE3 will work, and also why it may be more effective than QE2, the last iteration, which has led many critics to conclude that the Fed is out of bullets or declare a diminishing return on successive rounds of quantitative easing.  Krugman writes:

Now, what you learned back then was that the transmission mechanism worked largely through housing. Why? Because long-lived investments are very sensitive to interest rates, short-lived investments not so much. If a company is thinking about equipping its employees with smartphones that will be antiques in three years, the interest rate isn’t going to have much bearing on its decision; and a lot of business investment is like that, if not quite that extreme. But houses last a long time and don’t become obsolete (the same is true to some extent for business structures, but in a more limited form). So Fed policy, by moving interest rates, normally exerts its effect mainly through housing.

The reason why housing is a good way to influence the direction of the economy now (and why it has become a better transmission mechanism since QE2) is that rising house prices (particularly when the home equity is positive) is that it makes people feel wealthier and thus more willing to spend on other things.  Monetary easing also (as Krugman pointed out) affects the decision around investing in new long-term investments (like housing).

The effect on spending from the wealth effect (from rising house prices) is greater than from other sources because people buy houses with borrowed money (a mortgage).  This increases the feelings of higher wealth from rising house prices more than the percentage by which they increase.  And right now, house prices are just beginning to rise after several years of decline.   The Fed’s easing will help accelerate the rise in house prices.

In addition, there have been a lot of people with negative home equity (meaning they owe more on their houses than the houses are worth).  This has negative effects like a lowering of their wealth and also making them less mobile (if they are not working) to move to take a job.  As the negative equity decreases and prices rise so that they have positive equity, the wealth effect should be even larger, and we are heading in that direction according to a recent data release from CoreLogic:

CoreLogic … today released new analysis showing that 10.8 million, or 22.3 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2012. This is down from 11.4 million properties, or 23.7 percent, at the end of the first quarter of 2012. … Approximately 600,000 borrowers reached a state of positive equity at the end of the second quarter of 2012, adding to the more than 700,000 borrowers that moved into positive equity in the first quarter of this year.

And, how about new housing?  Well new house starts are going to be helped by more Fed easing and have been on the upturn as vacancy rates for both houses and apartments are declining (unfortunately the data for vacancy end in January 2011).

These factors are combining now in a way that they were not in previous iterations of QE.  We are also not in as dire straights as QE1 (Financial collapse) or QE2 (European debt crisis) so rather than just forestalling greater collapse, QE3 should be able to contribute to more economic growth, which will help to bring down the unemployment rate.