QE2: The Term
QE2—no, I’m not talking about the famous luxury cruise ship, nor am I talking about the Queen of England. QE2 is the new buzz word for the Federal Reserve’s attempt 
to stimulate the economy by increasing the amount of cash in circulation. QE stands for Quantitative Easing—money easing. The 2 indicates this is the second time the Fed has used this technique. The first QE took place from December 2008 through March 2010; the Fed added $1.7 trillion to the economy. Did QE work the first time? Did the economy begin to grow? Did we have job growth? Over the coming 8 months the Fed will add $850 billion to the money in circulation—a newly created $600 billion plus $250 billion left over from TARP. Will QE2 boost business and employment?
QE2: The Process
How does the Fed (the central bank of the United States) use QE2 to place additional cash in the system to stimulate spending, borrowing, and expansion? The Fed introduces the money through our nationwide banks, the ones you and I use every day. No, the Fed doesn’t walk through a bank’s side door nor in its back door carrying a suitcase of dollars. The Federal Reserve is a bit more sophisticated than that. They use a three step process.
- Step 1: The Fed creates the new money and adds it to its own checking account. The Fed is the only entity in the United States that can create money out of thin air. And how does it do this? It might chant, “Boil, boil, toil, and trouble,” as it stirs its caldron, or as it waves its magic wand, it might sing,
“With just a wave of my magic wand,
Your troubles will soon be gone,
With a flick of the wrist, And just a flash,
You’ll land a prince with a ton of cash,” or it might yell, “Full speed ahead. Keep the presses running,” as it prints the money. But in this electronic age, the Fed quietly fabricates the money with a few key strokes on its computer. Ooh, what happens if there is a slip of the finger and the Fed generates an extra billion dollars or turns a billion into a trillion.
- Step 2: The Fed transfers the newly created money to banks. The Fed can’t simply credit each bank’s account with more money. It must buy something from the banks in exchange for the money it hands out. The purchase must be something the Fed can hold, without deterioration, and resell at a later time if it so chooses. For QE2, the Fed is buying U.S. Treasury bonds owned by the banks—bonds that mature in five or six years and a few that mature in 30 years. Reportedly, the banks are disappointed the Fed isn’t buying more long-term 30-year bonds; the banks want to get rid of these higher risk bonds. However, the Fed doesn’t want to take on that risk either. Too many 30-year bonds would leave the Fed exposed to losses when interest rates rise. They would be holding bonds that pay 4.2 percent when new bonds might be paying 6 or 7 percent.
To encourage banks to sell their short-term bonds, the Fed is offering to buy the bonds for a higher price than the banks paid for them. The increased price also lowers the bond’s yield. As the price of a bond goes up, its yield goes down. Many everyday interest rates are based on the yield of these bonds. A major goal of the Federal Reserve is to keep interest rates low. The Fed has already used its standard approach for keeping interest rates low to stimulate the economy, and unemployment remains at 9.6 percent.
- Step 3: The banks start the money circulating in two ways. First, the banks lend the money to businesses so companies can expand and hire additional employees to get the economy moving again. Second, the lower bond yields may entice banks to move more of their investment capital into stocks. This demand will drive up the price of stocks and the market will rise. Other investors will follow. As the market continues to rise, individuals will feel wealthier and will begin to spend.
QE2: Why
Why is the Federal Reserve resorting to QE2? Previously, the U.S. government tried to stimulate the economy with the TARP monies through “shovel ready” projects and additional government hiring, but so far the economy has been uncooperative; unemployment remains at 9.6 percent. What are the hoped for and possible outcomes of QE2?
Stimulate the economy by providing additional money for banks to lend
The banks receive the newly created money from the Fed for a specific number of their U.S. Treasury bonds. Thus, the Fed creates additional money for loans. But, do banks lack the money to loan? Reportedly, banks are holding $1 trillion versus the normal $4 to $8 billion.
Or is the issue a lack of demand for loans from creditworthy borrowers? Why aren’t creditworthy businesses borrowing and expanding? Perhaps it is because companies are uncertain about the future—taxes, consumer demand, government action, regulations on the horizon, and general economic conditions. Reportedly, non-financial corporations are holding nearly $837 billion is cash as of the second quarter of 2010.
Why aren’t individuals borrowing and spending? Remember, 9.6 percent are out of work, people have seen the value of their 401Ks drop, and many are living in houses that are worth less the amount of their loans. They are uncertain what the future holds. Individuals are holding $8 trillion in cash and savings; furthermore, their savings increased 6.1 percent during the second quarter of 2010. Is there a lack of money in the system? Maybe there is a lack of money circulating. I, for one, am holding a significant amount of cash because of uncertainties—tax increases, a decline in the stock market, unrevealed effects of the health care bill, the possibility of Cap and Trade and its unknown effects. I may need my cash as cash. I’m holding it as a fear hedge against an unknown future. Did the Fed do any market research before it decided to implement QE2?
Maintain low interest rates
The Fed’s standard method of lowering interest rates—directly cutting them—has been exercised fully. The Fed is now resorting to its other tool, QE2. QE allows the Fed to adjust bond yields by choosing how much to pay for the bonds they buy from the banks—the more they pay, the lower the yield. The Fed feels it is important to keep interest rates low to encourage business and consumer borrowing. The interest rates are already at record lows, and the lack of borrowing and expansion continues. Is the lack of available loans at low interest rates the problem? Perhaps business and individuals are quietly waiting to see what happens? Companies and individuals seem reluctant to incur debt at this time.
Boost the stock market
Federal Reserve Chairman Ben Bernake has suggested that by adding money to the banking system, the banks will take the money they don’t loan and will use to buy stocks and corporate bonds rather than low interest U.S. Treasury bonds. Increased demand for stocks means increased stock prices. If the stock market goes up, it creates the impression the economy is recovering. If the economy looks like it is recovering, we will feel that we have more money and will begin to spend; that will lead to increased employment. The Fed is simply creating demand for stocks by keeping bond yields very low and by adding money to the system. If this occurs, investors should be aware that this demand for stocks may not be built on strong company fundamentals such as increasing sales and earning growth rates.
Monetize the U.S. debt
Monetizing the debt means the U.S. government buys its own debt. The Fed creates money out of “thin air” and buys the U.S. debt held by nationwide banks. This puts newly created money into circulation and keeps interest rates low—aka money easing—while decreasing bank-held U.S. debt. QE2—monetizing the debt—is the only method the Fed has left to use to stimulate this economy and keep interest rates low.
Throughout history and around the world monetizing debt has been a “no-no.” What’s wrong with monetizing the debt? It devalues the currency; it devalues the dollar by putting extra dollars in circulation—dollars that come from a nonproductive event. Monetizing our debt does not raise our gross domestic product (GDP).The new dollars do not come from the production of a product or a service.
When the dollar is devalued, each dollar buys less, which leads to inflation and often hyper-inflation. Governments find it difficult to control inflation and painful to wring high inflation out of the economy. All goods and services become more expensive and their prices keep going up. Inflation is particularly difficult for people living on fixed incomes.
Globally, a weaker dollar—a less valuable dollar—makes our goods less expensive for other countries to buy. This may increase out exports which in turn may put more people to work in these industries—civilian aircraft, semiconductors, vehicle parts and accessories, industrial machinery, organic chemicals, telecommunications equipment, plastic materials, and medicinal, dental and pharmaceutical preparations. Yet, a devalued dollar makes everything we import more expensive—crude oil, cars, medicinal preparations, automotive accessories, cotton apparel.
In Conclusion
In the final analysis, the Fed anticipates that buying $600 billion of existing U.S. Treasury bonds from banks and paying for them with newly printed money will supply cheaper and additional loan resources for businesses, consumers, and home buyers. The Fed believes this will stimulate additional borrowing, spending, and growth. Also, the Fed hopes the lower interest rate and return on government bonds will push investors into stocks. The increased demand for stocks will drive the market higher and help us feel wealthier so we resume spending.
