The Federal Reserve announced yesterday their most recent policy decision regarding interest rates.  In their announcement – widely anticipated and largely telegraphed but never a sure thing until released – the Fed is implementing what is being referred to as QE3 or a third round of quantitative easing.  The Fed intends to purchase about $40 billion worth of MBS or mortgage backed securities (bonds that are backed by mortgages guaranteed by agencies such as Fannie Mae, Freddie Mac or Ginnie Mae) per month.  In addition, the Fed announced that interest rates were being held effectively at zero (actually between 0 – 0.25%) through mid-2015.  All of this is an attempt to lower unemployment and get the economy growing at a healthy clip again.

The bottom line to QE3 is that money is being pumped into the economy at a fast and furious rate.  The Fed is hoping that, with interest rates being kept low and money freely available, businesses will start investing again, hire new employees and kick start our economic engines.  The reality of QE3 is that our economy is awash in money that is seemingly going nowhere.  The first round of quantitative easing occurred just after the economic crisis of 2008 when the Fed bought MBS and Treasury bonds from banks in order to help boost banks’ liquidity.  That round of quantitative easing is credited – along with other measures taken by the government – with keeping the U.S. economy from falling into a depression.  However, when it was obvious that our economy was barely moving, a second round of easing was announced in late 2010 (QE2).  It’s widely accepted that the QE2 round of easing did little to help lower the unemployment rate.

I’m not writing this to bore you with any policy details, however.  I just wanted you to have an understanding of where we are as we enter QE3.  The total amount of new money that has been pumped into the economy through the first two rounds of easing is around $2 trillion, give or take a few billion (what’s a few billion among friends?).  With the announcement yesterday, there was no specific quantity given as to how much will be spent buying back these mortgage bonds, but we can expect this to occur through the end of this year.  In fact, Ben Benanke, the Fed Chairman, left the total to be spent open-ended.

The key issue to all of this background is the idea of inflation.  Any time a country creates money out of thin air by printing new currency (that is, without retiring a like amount of old and worn out currency), there is a risk of inflation popping up.  This is a simple rule of economics.  If there are more dollars floating around, merchants will charge more for their goods leading to price inflation.  The biggest fear is that these actions by the Fed will eventually lead to rampant inflation in our economy as there will be an additional $2.5 – $3 billion in money floating around that wasn’t there before.  This is a legitimate fear and one that we here at Aerie have been keenly aware of for some time.  However, the truly odd thing is that we have not seen much evidence of price inflation.  Typically, when we see inflation, we expect to see prices of assets increase across the board.  You would anticipate that, not only would gasoline cost you more but so would your groceries and computers and houses.  However, officially, the current inflation rate is only about 1.7% annually (as of August).  So where is all of this money going, if not into goods and services?  In all likelihood, it’s all going into financial assets.

After the market reaction to the Fed’s announcement yesterday, we are convinced of two things.  One is that we are entering a new bubble.  The other is that until this bubble deflates, we really don’t have any worries about major crises facing the markets.  There are currently a couple of potential events on our horizon.  One is, of course, Europe.  Europe is still having financial difficulties.  Greece cannot seem to get their austerity act together (would you really want to give up as much as 20% of your salary?), Spain is still teetering on the brink of bankruptcy and all the European Central Bank (ECB) can do is provide more loans to these countries in exchange for more austerity promises.  In spite of what the ECB’s head, Mario Draghi, has said about defending the Euro, we are not out of the woods yet on this crisis.

On the home front, the U.S. is facing the so-called “fiscal cliff” at the end of the year.  This is when the Bush tax cuts expire and, unless Congress actually figures out how to work together and find true compromise, a process called ‘sequestration’ will take effect.  This is an agreement that goes back to the debt ceiling debate last year.  In a compromise, the debt ceiling was raised in exchange for an agreement to create a committee that would find $1.2 trillion in debt reductions over the next ten years.  As incentive for this committee to find the cuts, if they could not agree then, effective Jan 1, 2013o there would be an automatic enactment of $1.2 trillion in cuts split relatively evenly between defense spending and discretionary spending (i.e. social programs).  This means both parties would lose some of their ‘sacred cows’.  Of course, the committee could not find any compromise, so sequestration is set to take effect in January.  The truth of the matter is, this really won’t have a major effect on the budget for 2013 as the budget Obama has proposed for 2013 (though never voted on and adopted by Congress) already takes these cuts into account.  However, the appearance of not being able to work together to solve our own fiscal problems could lead to another debt downgrade and more volatility like we saw in July and August of last year.

With those issues in front of us, we have been worried about a meltdown, but it is now obvious to us that we have little to fear.  The money the Fed is pumping into our financial system has to go somewhere and that somewhere is into stocks and bonds.  That does not mean we have a straight shot to the moon.  There will certainly be volatility, but it does mean that we would seem to have an implicit “floor” under our markets.  If things get too rough, the Fed will step in with more money that will flow into the markets supporting stock prices at some level.  This affords us the opportunity to sell some of our weaker names into strength and to add to stronger names or pick up new names on any weakness that is sure to occur.  We have several stocks that we are looking at adding to portfolios but we have also set appropriate price thresholds that we feel provide a margin of safety for us.