The asset purchase program
The Federal Reserve’s asset purchase program has been successful in its objective so far. The Fed’s asset purchasing, also known as quantitative easing (or QE), is the program through which the Fed has been buying agency mortgage-backed securities and longer-term Treasury securities each month to provide the market with much-needed liquidity in order to facilitate increased economic activity and growth. With greater credit availability, business and commercial activity has picked up, supporting labor market growth.
In September 2012, the Fed decided to provide an open-ended commitment to purchase $40 billion agency mortgage-backed securities per month until the labor market improves substantially. In December 2012, it added $45 billion worth of longer-term Treasury securities to its commitment.
Since then, the Fed has tapered its QE program four times by $10 billion each time. In the FOMC meeting held on June 17–18, the FOMC decided to make a further deduction to the pace of its asset purchase program by another $10 billion. As a result, the current level for the Fed’s monthly purchase of agency mortgage-backed securities stands at $15 billion, while it purchases of longer-term Treasury securities stands at $20 billion. So the current level of the Fed’s total monthly asset purchases stands at $35 billion.
However, the committee will maintain its existing policy of reinvesting principal payments from these holdings in agency mortgage-backed securities and rolling over maturing Treasury securities at auction.
The Fed’s balance sheet
The FOMC’s asset purchase program is increasing the size of these long-term holdings on the Fed’s balance sheet every month. This should put downward pressure on long-term interest rates. With credit available at low interest rates, the mortgage market should see recovery along with promoting stronger economic recovery by making credit available at cheaper rates. Over the long term, this will promote economic growth.
The Fed’s asset purchase program is intended to provide enough liquidity to the market to keep the Fed funds rate low. Once the Fed sees that the economy has recovered and can sustain itself even if the Fed tightens the liquidity it’s providing in the market, it may start increasing the Fed funds rate.
Defensive sector ETFs like the Merrill Lynch Pharmaceutical HOLDRS ETF (PPH), which tracks the performance of 25 of the largest U.S.-listed pharmaceutical companies, could do well during the early part of a tightening cycle. Similarly, the SPDR Technology Select Sector Fund ETF (XLK) and the Vanguard Information Tech ETF (VGT), which has major holdings in information technology companies like Apple Inc. (AAPL) and Google, Inc. (GOOG), could protect investors from the interest rate risk arising out of a Fed funds rate rise.
The next part of this series discusses the committee’s decision to continue its tapering initiatives as long as economic activity keeps improving.