MarketWatch: November 1-5, 2010

All eyes have been on the Fed this week. And the Fed delivered, with more ammunition than expected for its second round of quantitative easing (known as QE2). On Wednesday, it announced a bold move to jump-start the economy by buying $600 billion in Treasury securities between now and June. The Fed also confirmed a decision from August: it will continue to reinvest principal repayments from its Fannie and Freddie-related holdings in Treasuries. With principal repayments estimated at $250-300 billion, the Fed estimates its total additional liquidity support for the economy at $850-900 billion over the next 8 months, with adjustment possible either way depending on circumstances.

The Fed’s stated objective is to push longer-term interest rates down to stimulate economic activity, especially to help the struggling mortgage market and a still weak financial sector otherwise, but also to boost big ticket expenditures. The Fed turned once again to the extraordinary step of buying Treasury securities because it has no more room to lower the federal funds rate (its normal policy instrument), which is close to zero.

Markets have so far reacted very positively to the Fed announcement, even though initial market reaction was a little confusing. Interest rates on 30-year bonds went up instead of down at first, apparently because the Fed announced it would buy less 30-year bonds than markets had anticipated.

But global financial markets and policymakers have not been so positive. The Fed’s stimulus moves are in the opposite direction of what most countries are doing now. Many other G-20 countries are consolidating fiscally, not changing monetary policy or under pressure to tighten. We can see the relative impact of the Fed’s shift in currency markets: the dollar has declined against the currencies of its major trade partners, as the return elsewhere now appears more appealing. Other countries are worried that a weaker dollar and accompanying capital inflows to their countries will be destabilizing, although they will also benefit from stimulative effects of a lower dollar on U.S. growth. In the run-up to the G-20 in a few weeks, policymakers (including central bankers) – many of whom are key financiers of our national debt - may increasingly call for the U.S. to put its stimulus measures within the context of longer-term fiscal discipline.

Released this morning, October’s employment figures are supporting positive market sentiment, although labor market weakness clearly continues. Based on October’s numbers, we see that the private sector is hiring, but not by enough to make a dent in the unemployment rate, which stayed at 9.6 percent. Other indicators of unemployment duration and discouraged workers suggest that conditions show little change.

As the dust settles on the election, our country’s fiscal direction remains highly uncertain and we are starting to see back-and-forth among policymakers in the run-up to the lame duck session and beyond. There could be many fiscal items on the lame duck agenda, including whether to renew all or some of the expiring tax cuts (see our previous blog on Congress's To Do List). In addition, today’s employment numbers are a reminder that unemployment insurance legislation expires at the end of November.