Markets experienced a sharp rally last week as the Federal Reserve unleashed its long-expected quantitative easing. The major indices closed higher with The S&P gaining 1.94%, the Dow gaining 2.15%, and the Nasdaq picking up 1.52%.

Under the pressure of the previous week’s disappointing jobs report, the Fed finally let the genie out of the bottle. The report showed that the economy had added just 96,000 jobs in August, a number much lower than economists expected.[i] This was enough to get the Fed to finally launch long-awaited additional quantitative easing. Under QE3, the Fed has made an open-ended commitment to buy mortgage-backed securities to the tune of $40 billion per month. The move is designed to lower long-term interest rates and spur more lending to businesses and consumers. The Fed said it also will “closely monitor” the economy and continue these purchases and possibly expand them until it sees substantial improvement in the outlook for the labor market.[ii] This open-ended commitment means that QE3 will last as long as the Fed wants it to and we cannot be sure when it will end.

The Fed’s recent action sends a signal to businesses and investors that it fully intends to use its powers in a major (and unusual) way to spur economic growth. That is a powerful statement to make in a time of economic uncertainty. QE3 is designed to convince businesses to invest in the future by assuring them that the Fed stands ready to do whatever is necessary.

On the negative side, our concern is that QE3 will simply add to the already enormous national deficit without dealing with the underlying causes of our current economic weakness. We are also skeptical that the Fed’s actions will convince banks to lend aggressively; rates are already at historic lows, but businesses and homeowners are still having trouble borrowing from gun-shy lenders. In short, QE3 is not a magic bullet that will solve our economic issues. In fact, it may actually add to our problems when the Fed is forced to unload all the bonds it has purchased – not just the QE3 bonds, but the $2 trillion in Treasury bonds it bought during QE1 and QE2 as well. Selling all that debt will drive up interest rates and may stall the recovery just when it has finally taken off.

So, what can we expect next? It’s clear that markets are jubilant about finally seeing what the Fed had in store. However, once investors get over their reaction high, if the economic numbers don’t show improvement, markets will likely retreat. Although we hope that businesses respond positively to the Fed’s move by increasing hiring and capital investment, we really want to see Congress pull itself together enough to address the fiscal cliff and tighten its purse-strings. If you have any questions about how QE3 or any economic issue will affect your portfolio, please feel free to call or e-mail us. We are delighted to be of service.

ECONOMIC CALENDAR:

Monday: Empire State Mfg. Survey

Tuesday: Treasury International Capital, Housing Market Index

Wednesday: Housing Starts, Existing Home Sales, EIA Petroleum Status Report

Thursday: Jobless Claims, Philadelphia Fed Survey