Understanding QE2 — and what could go wrong

by Mark on November 3, 2010 7:06 am · 5 comments

qe2 - quantitative easingThe fed is about to announce the size of their quantitative easing efforts. And it comes with great risk. I get asked a lot just what is QE2, and today I ran across an article that explains it very well in plain, layman’s language. Pass it along to any of your friends who need a clear understanding of what quantitative easing is, and what could go wrong with this desperate attempt to keep us from fiscal ruin.

The Federal Reserve is about to take a huge risk in hopes of getting the economy steaming along again. Nobody is sure it will work, and it may actually do damage.

The Fed is expected to announced today that it will buy $500 billion to $1 trillion in government debt, and drive already low long-term interest rates even lower. The central bank would buy the debt in chunks of $100 billion a month, probably starting immediately.

Economists call it “quantitative easing.” It gets the name “QE2″ — like the ship — because this would be the second round. The Fed spent about $1.7 trillion from 2008 to earlier this year to take bonds off the hands of banks and stabilize them.

Here’s how it’s supposed to work this time: The Fed buys Treasury bonds from banks, providing them cash to lend to customers. Buying so many bonds also lowers interest rates because demand for Treasurys leads to higher prices and lower yields. Interest rates are linked to yields. Lower rates encourage people to borrow money for a mortgage or another loan.

At the same time, lower interest rates make relatively safe investments like bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, like stocks. The S&P 500 takes off and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues.

But many analysts and even supporters of the plan see dangers. It could make the weak dollar even weaker and lead to trade disputes with other countries. It could lead bond traders to believe that higher inflation is on the way, and they could derail the Fed’s efforts by pushing rates higher. Many investors argue that it may create bubbles as hedge funds and other speculators borrow cheaply and make even bigger bets on stocks, commodities and markets in developing countries like Brazil.

“It’s a desperate act,” says Jeremy Grantham, co-founder of the investment firm GMO. Grantham says it’s a clear message from the Fed to the rest of the world: “The U.S. doesn’t care if the dollar weakens.”

Here is a look at the ways the Fed’s strategy could backfire:

Read the whole article here: AP


{ 2 comments… read them below or add one }

Travis July 21, 2011 at 10:29 am

Get ready for QE3!

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Gordon Shumway August 10, 2011 at 3:08 pm

Two questions:
1. Why is it a felony for an individual to print money, but evidence of a keen insight into the arcane world of macroeconomics when a bankster does the same thing, only on a vastly greater scale?
2. Since those who are running the Fed and Treasury are supposed to be the smartest people in the world, yet nothing that they have done is having the effects that are supposedly desired, why are they not conclusively regarded as utterly incompetent, evil, or both?

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