Quantitative Easing (QE) 2

This week’s blog is about the US Fed’s (Federal Reserve) announced policy of quantitative easing 2. On November 3 the Fed announced that it intends to buy an additional $600 billion of longer-term treasury securities by mid 2011, which equates to about $70 billion per month. The Fed will continue to review the size of its overall securities purchases and the overall size of the program; after reviewing incoming data, they will adjust the program as needed to increase employment and keep prices stable.

Why is the Fed doing Quantitative Easing 2? The US continues to experience persistently high unemployment. Job growth of between 150,000 and 200,000 per month is required just to absorb the new employees entering the job market. The current GDP growth rate is around 2% and the inflation rate is less than 2%. Over the last 2 years the Fed and the US government have tried a number of programs in their attempts to jump start the economy and increase employment.

Examples of programs the US government and the Fed have tried over the last 2 years:

Fed fund interest rate: The Fed has decreased the fed fund interest rate to a historic low of .25% (it was 4.75% in 2007). It can only go down to 0%. At this level the Fed cannot use this to kick start the economy and increase employment. Home mortgages are at a record low.

Large federal government stimulus: In 2009 Congress passed and President Obama approved a $787 billion stimulus package to help stimulate the overall economy and employment growth. With the enormity of the budget deficit and the Republican Party taking over the House of Representatives there is little or no political will for a new federal government stimulus in 2011.

QE 1 (2009): The Fed started quantitative easing 1 back in March 2009 when it began a program of outright purchases of treasury coupons, GSE debt and mortgage-backed securities. QE1 lasted about 1 year and the Fed increased the money supply by about $600 billion.

This was not the first time the US government used cutting fed fund interest rates and large stimulus programs to stimulate the economy. For the first time in US history it has not been successful. Without the ability to lower the fed fund rate (it could go to 0%) and without Congress having the will to approve a new large stimulus program the Fed thinks the only arrow left in the economic stimulus policy quiver is to carry out QE 2 to help the economy grow and increase employment.

What is Quantitative Easing (QE) 2? In very simple terms, it is injecting (printing) money directly into the economy. This is supposed to lower interest rates and increase the money available for lending. How are the Feds doing this? The Fed will distribute new money at a rate of $70 billion per month and go to financial institutions to buy $70 billion of government bonds at a higher rate than others will pay for them. In a perfect world the financial institutions will then lend out money to companies or people who will in turn invest or spend it. This should pave the way toward overall economic growth.

Issues and problem with QE 2: The major problem with quantitative easing is that it will devalue the US currency. This has the positive effect of making US exports cheaper (it is a positive for companies that export and should help their stock price) for companies or consumers outside the US. It will have the opposite effect with imports which will become more expensive for US companies or consumers to buy. This can lead to currencies wars with countries that export to the US since their products will be more expensive which would tend to decrease demand for them. They may need to devalue their currencies to be able to sell in the US. Since most commodities are valued in $ US it will drive up the cost of commodities. This may have a negative effect on poor people around world since they spend a greater percentage of their money on commodities such as food, fuel, etc.

The positive effect of QE 2 is that interest rates may decrease which will in theory help to grow the economy. This will assist consumers or companies that need loans, for example to refinance their homes (and have more money to buy goods), buy homes, cars, etc. and for companies to purchase new equipment. This has a positive affect for people that need to borrow money and negative effect for people or companies that save money (they will receive lower interest yields and their dollars will be devalued).

Is it working? It is still early to determine if QE 2 is working. Since it was put into effect on November 2 all the Fed treasury bills, notes and bonds yields have increased (as of November 19th). For example, 7 year and 10 year treasury notes have increased 33 basis points (a basis point is .01%) and 30 year bonds have increased 32 basis points. The reason for this might be that investors perceive quantitative easing 2 will feed inflation in the future. Success may also be subverted if financial institutions will only lend money to consumers with high credit worthiness (unlike pre financial crisis when almost anybody could get a mortgage).

Please chime in with comments about QE 2. Do you think it will help the economy, will it lead to currencies wars and stagflation, increase commodity prices, etc. Future blogs that I will be writing:

Income generating bucket of money

Investing in possible buyout companies

Investing in Brazil

Using Fisher’s Common Stocks and Uncommon Profits and Other Writings15 points for researching companies to evaluate one company

Best investments for Quantitative Easing (QE) 2

Paul

© 2010 Paul Cusick