As expected, the Federal Open Market Committee has embarked on another round of planned asset purchases. In its November 3 policy statement, the FOMC wrote that it expects to buy another $600 billion in long-term Treasuries by the end of 2Q11 ($75 billion per month), in addition to the $35 billion per month in reinvested principal payments from its portfolio of mortgage-backed securities. There has been much criticism of the move in the financial press. Certainly, there are risks in the Fed’s strategy. However, it’s hardly reckless or ill-advised.

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Weekly Commentary by Dr. Scott Brown
The Fed’s Asset Purchases
November 8 – November 12, 2010
As expected, the Federal Open Market Committee has embarked on another round of planned asset purchases. In its
November 3 policy statement, the FOMC wrote that it expects to buy another $600 billion in long-term Treasuries by
the end of 2Q11 ($75 billion per month), in addition to the $35 billion per month in reinvested principal payments
from its portfolio of mortgage-backed securities. There has been much criticism of the move in the financial press.
Certainly, there are risks in the Fed’s strategy. However, it’s hardly reckless or ill-advised.

2. The Federal Open Market Desk in New York plans to distribute its purchases across the following eight maturity
sectors based on the approximate weights below:
Nominal Coupon Securities by Maturity Range TIPS
1½ -2½
Years
2½-4 Years
4-5½
Years
5½-7
Years
7-10
Years
10-17
Years
17-30
Years
1½-30
Years
5% 20% 20% 23% 23% 2% 4% 3%
Why it the Fed expanding its balance sheet? The economy is in a liquidity trap. Short-term nominal interest rates are
near 0%. In a liquidity trap, fiscal policy is more effective at boosting growth than monetary policy. However, with
fiscal stimulus unavailable, or possibly negative, monetary policy is the only game in town – and it can be effective,
not through increasing the money supply, but by altering expectations.
Quantitative easing is not something that the Fed just made up. It’s textbook economics (granted, at the upper
division or gradual level). People have been thinking seriously about liquidity traps and how to get out of them for a
long time. That doesn’t mean there aren’t controversies. Plenty of smart people have their doubts. However,
comments that quantitative easing is “reckless,” “financial heroin,” or other such nonsense are not based on any
theory of monetary policy.
So why is the Fed doing this? Basically, it’s real interest rates that matter. Inflation is too low, making real interest
rates too high. The Fed’s actions should lift inflation expectations (and apparently already have). Lower real interest
rates are stimulative. And as mentioned, fiscal stimulus is unavailable.
So what are the legitimate worries about quantitative easing? The Fed has relatively little experience with this. The
Fed’s first round of asset purchases (mostly mortgage-backed securities) was helpful in stabilizing the financial
system, largely because the Fed bought mortgage-backed securities when nobody else would. This second round is
different. Many fear that the Fed could be too successful in raising the inflation rate and could possibly generate
hyperinflation. However, the key here is the independence of the Fed and its commitment to keep inflation low over
the long run. The federal government has been generating more debt and the Fed is taking down some of that debt,
but those are separate decisions. In a Washington Post op-ed, Fed Chairman Bernanke wrote that the Fed has the
tools to unwind these policies at the appropriate time and “will take all measures necessary to keep inflation low and
stable.” Ironically, the commitment to keep inflation low over the long term diminishes the effectiveness of its asset
purchases (because the goal is to increase inflation expectations). However, the Fed’s strong commitment to low
inflation signals that it won’t let things get out of hand.
One consequence of increased asset purchases (or any monetary policy easing) is higher commodity prices and a
somewhat softer dollar. However, a weaker dollar is not the goal (remember that the exchange rate of the dollar is the
Treasury’s responsibility, not the Fed’s).
Many worry about a possible bubble in the emerging economies (Latin America, East Asia, etc.). Following the global
financial crisis capital flows to these countries picked up. Certainly, this bears watching in the months ahead.
Does the stronger-than-expected Establishment Survey data (from the October Employment Report) change the
outlook? Not much. Private-sector payrolls averaged a 136,000 gain over the last three months – that’s enough to
keep the unemployment rate steady over time, but not enough to push it significantly lower. Job growth is still much
too slow.
In his Washington Post op-ed, Bernanke wrote that “the Federal Reserve cannot solve all the economy's problems on
its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the
administration, regulators, and the private sector. But the Federal Reserve has a particular obligation to help
promote increased employment and sustain price stability. Steps taken this week should help us fulfill that
obligation.”

3. More Of The Same
November 1 – November 5, 2010
Real GDP rose about as expected in the third quarter. Details were mixed, but remained consistent with the view that
the pace of growth, while still positive, is subpar – far below a rate that would be associated with a significant
reduction in unemployment. What to expect from here? More of the same, most likely. The economy continues to face
a number of serious headwinds, but the recovery is likely to remain on track.
It was the best of times, it was the worst of times. The good news is that the recovery, which began in June 2009, has
continued. The economy is growing. The bad news is that it’s not growing fast enough. We need to see real GDP
growth on the order of 4%, 5%, or 6% to put much of a dent in the unemployment rate. Real GDP rose 3.1% over the
four quarters ending 3Q10, but a good chunk of that was an inventory rebound. Imports have a negative sign in the
GDP calculations, and higher imports in the last two quarters have subtracted significantly from overall GDP growth.
Domestic Final Sales (GDP less net exports and the change in inventories) rose 2.1% y/y, better in the last two
quarters (a 3.4% annual rate) than in the previous two quarters (+0.8%).
So what’s holding the recovery back? In a typical business cycle, the Fed raises short-term interest rates to cool
inflation pressures, often leading to a downturn in the overall economy (a recession). The Fed then lowers interest
rates and the economy recovers. However, the current downturn was not caused by higher interest rates. In turn, a
reduction in interest rates should not be expected to turn things around right away. Recessions that are caused by
financial crises tend to be long and severe – the recoveries tend to be very gradual. Simply put, it takes time to repair
household and business balance sheets. That process is well underway, but it is far from over. Plenty of cash lying
around, but there is still a crisis of confidence.
Residential housing problems clearly remain. Delinquencies and foreclosures are likely to remain elevated for some
time. Residential homebuilding is a fairly small part of the overall economy (normally about 4.5% of GDP, it rose to a
little over 6% of GDP during the boom, and is now about 2.5% of GDP). During the previous decade, many households
extracted equity as home values were rising. Some of that went to home improvements, some went to pay down other
forms of debt, and some was simply spent (boosting consumer spending and helping to offset a negative drag from
higher gasoline prices). That game is over. Consumer spending is now back to being driven mostly by job growth,
which hasn’t been spectacular.

4. The personal savings rate is a flawed statistic, subject to large revisions, but recent figures suggest that households are
saving more than they were before the financial crisis (or equivalently, are paying down debt). The increase in savings
made the downturn more severe than it would have been otherwise (since one person’s spending is another person’s
income). It remains unclear whether the savings rate will settle where it is, decrease somewhat, or head higher.
The business outlook is mixed. Corporate profits have rebounded in the economic recovery, helping to fuel spending
on business equipment and software – but not new hiring. Smaller firms are still subject to tight credit and we
normally look to the smaller, newer firms to account for a lot of the job growth during an expansion. That’s not
happening currently.
Many investors are likely to be encouraged by the election results this week. However, gridlock in Washington means
that little is likely to get done in the near term. While austerity is well meant, history shows that raising taxes in a soft
recovery is a bad idea. Will there be a compromise on taxes before the end of the year? It’s hard to say, but the
uncertainty will remain a negative for the economy and for the markets. Higher taxes may dampen growth, but
growth should stay positive in 2011.
Key Dates Approaching
October 25 – October 29, 2010
The first week of November looms large for the markets. The November 2 mid-term elections are expected to result in
a power shift on Capitol Hill – but how much will actually change? The Fed’s November 3 monetary policy decision
has important implications for interest rates, the dollar, and the economy in general. The October Employment
Report (due November 5) will help shape the near-term economic outlook and set expectations for future Fed policy
moves.
For those of you who slept through civics class in high school, recall that all 435 seats in the House of Representatives
are contested every two years. Senators serve six-year terms – so about of third of the 100 seats in the Senate are
contested every two years (37 seats are being contested this year, due to the death of Robert Byrd and the resignations
of Joe Biden and Hillary Clinton). As we head toward the wire, there are a number of close races. Recent polling
suggests that the Republicans have a good chance of regaining a majority in the House and a small chance of taking
control of the Senate.
Will the election results change anything in Washington? It will in the House, where a simple majority is needed to
pass legislation. The Senate is more complicated. As it is now, the Democrats have a 59 seat in the Senate, one short of
a supermajority. You need 60 votes in the Senate to avoid the threat of a filibuster – and thus, you need 60 votes just

5. to be able to vote on a bill. In addition, one senator can put a hold on any or all legislation, meaning that the floor
leader is informed that the senator does not want a particular bill to come to the floor for a vote (and implicitly
threatens a filibuster of any motion to consider the measure). So, anyone believing that a Republican victory will lead
to a dramatic change in the direction of legislation will be disappointed.
Yet, perceptions matter. The stock market is likely to view a Republican majority in the House as a check on the White
House. During the Clinton years, gridlock was good. The Republicans didn’t get massive tax cuts and the Democrats
didn’t get any major spending programs, and we ended up with a federal budget surplus (the Clinton era was also well
served by PAYGO rules, which required any legislative changes to be budget neutral). However, in the current
environment, stuff might actually need to get done to boost the economy. While there are bound to be disagreements
about the best way to do this, nothing significant is likely to get done.
The Fed’s November 3 policy decision is not a done deal. There are differences of opinion, but most Fed officials,
including Chairman Bernanke, have been leaning toward further monetary accommodation. The key element is
expected to be an announcement to purchase a specified amount of long-term Treasuries over a certain period of
time. This should be on a much smaller scale than in the first round of credit easing ($1.25 trillion in mortgage-
backed securities and $300 billion in Treasuries purchased last year), allowing the Fed more flexibility (to do more if
needed or to stop if growth picks up). Will quantitative easing be inflationary? Yes, hopefully – at least to some extent.
Inflation is too low for the Fed’s comfort. It’s real (that is, inflation-adjusted) interest rates that matter. The drop in
inflation expectations has lifted real rates, dampening the pace of economic growth. Raising inflation expectations
would lower real rates, stimulating growth. Still, it’s not an easy decision. There are positives and negatives to just
about any Fed policy decision. Many fear that the Fed will not be able to withdraw accommodation in time and fuel
substantial higher inflation in the future. However, officials are confident that the Fed can drain bank reserves in a
timely manner when appropriate. The Fed has spent much of this year testing the exits (reverse repos, term deposits
for depository institutions).
The Federal Open Market Committee may announce efforts beyond asset purchases. It may commit to a longer period
of low short-term interest rates. It could also announce an inflation target or a target rate for long-term Treasury
yields.
After the shock and awe of the mid-term elections and the Fed policy decision, the financial markets will face the
October Employment Report. The impact of the 2010 census is behind us. Since January 2009, federal government
payrolls have risen a bit less than the rate of population growth (so much for the “massive” expansion of government).
State and local government payrolls have fallen, reflecting budget strains (despite federal aid to the states), which has
acted as moderate drag on overall economic growth. Private-sector job growth has been positive, but relatively subpar

6. in recent months. Expect more of the same in the job report for October.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more
information about this report – to discuss how this outlook may affect your personal situation and/or to learn how
this insight may be incorporated into your investment strategy – please contact your financial advisor or use the
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