World financial markets gyrated after the recent testimony of Fed Chairman Ben Bernanke. They did not like what they heard: the Fed could slow QE3 or the purchases of long-dated Treasury Securities and Mortgage-Backed Securities (MBS) (some literature calls MBS buying since September 2012 QE3 and long-dated treasury buying since December 2012 QE4).
Considerable effort is being expended in trying to understand when the Fed could slow QE3. To avoid confusion it is important to note that Fed policy is two-layered – there is the near-zero short term federal funds rate and then there is QE3 or long-dated treasurys and MBS buying.
The Fed prepares both short term and long term borrowers before changing rates to ensure, especially in shadow banking, rate sensitivities are properly hedged and financial crises do not result as had happened in 2007-2008.
The short term federal funds rate, targeting inflation of 2.0 and unemployment of 6.5, is expected to remain at near-zero through at least mid-2015 providing inflation outlook is within 2.5.
QE3, on the other hand, is tied to the housing market where typically the mortgage rates are indexed to long term treasury securities (MBSs backed by adjustable rate mortgages are indexed to short rates). Buying long-dated treasuries and MBSs depresses long term mortgage rates and long term interest rates and thus buoys the housing market and more generally the market for long term capital investments in the economy.
QE3 could be slowed by the Fed if and when the Fed concludes that the housing market has recovered self-sustainably and long term investment growth is in steady state.
Given that the housing market has recovered the Fed could more likely decide to end its MBS purchases by the September meeting of the Federal Open Market Committee (FOMC).
Lowering long term interest rates through the purchase of 10 and 30-year treasurys has broader impact on the economy as a whole and, therefore, the FOMC could decide to taper its buying of long-dated treasurys also by September to prevent the formation of asset price bubbles while being supportive of the economic recovery underway.
Economic recovery has been the raison d être of QE. QE is not necessary upon a self-sustaining recovery, however slow or fast that recovery may be. The recovery underway is self-sustaining albeit slow, therefore, QE can be tapered to end.