The Market’s Reaction to QE3 Is a Little Unnerving

The Fed’s QE3 program involves the purchase of $85 billion per month of mortgage-backed securities. In June, when the Fed suggested it might “taper” this down to $65 billion, markets tanked. Yesterday, when the Fed reversed course and announced that this wouldn’t happen, bond and equity markets were euphoric and shot upward on the news.

Felix Salmon thinks—almost certainly correctly—that the size of the response to yesterday’s news far outstrips the size of the potential change in Fed bond purchases:

If that is indeed the case, then what we’re seeing is what you might call the QE multiplier — the amount by which every dollar of QE effects the markets as a whole. I don’t know what we thought the QE multiplier was on Wednesday, but in light of Thursday’s market action we might need to revise our guesses: the QE multiplier is, I suspect, much larger than most of us would have pegged it at.

This doesn’t worry Salmon. In fact, he thinks it’s a good thing. It shows that the Fed’s policies have a big bang for the buck.

I agree. And yet….there’s something worrisome about it too. Right now the economy is still fragile, so it’s not surprising that investors reacted positively to evidence that the Fed plans to continue its support. But it’s not that fragile, is it? The reaction of the market really does seem out of whack with the likely impact of the Fed’s program.

So we have a few possibilities. The first is that QE3 has a big impact and investors realize that. Alternatively, it could mean the economy is more fragile than we think and investors are reacting to that. Or maybe it’s not especially fragile, but markets don’t believe it and are far more skittish than they should be. Or it could mean that QE3 is mainly just a profit-making opportunity for financial institutions, and they’re reacting rationally to it.

Three out of four of these are bad things. I’d feel a lot better about yesterday’s news if I were sure that none of them was the real explanation for the market’s apparent euphoria.