The Fed is expected to launch another round of quantitative easing, a move some consider a risky gamble that won't work. Image: CC banspy/Flickr

A much-anticipated second round of quantitative easing from the Federal Reserve is expected this week. In a move known as “QE2,” the Fed is expected to buy Treasury securities to flood money into the economy, make it easier to borrow and spend, and reduce the likelihood of deflation. Some experts think QE2 is a risky move that could weaken the Fed and trigger inflation without having the desired effect.

QE2: Money from nothing

The Federal Reserve Open Market Committee will meet to discuss monetary policy Tuesday while the country is conducting midterm elections. The Fed has been waiting until after the election to announce additional measures to stimulate the economy. Most experts, traders and investors expect the Fed’s next move to be another round of quantitative easing. Fed chairman Ben Bernanke has said that deflation is emerging as the biggest threat to economic recovery. QE2 is an attempt to prevent deflation. By buying Treasurys, the Fed is essentially creating money from nothing and infusing it into credit markets. In theory, interest rates will stay low, lending will increase, and the economy will be stimulated.

QE2 the Fed’s only remaining option

The first round of quantitative easing began when the economy collapsed at the end of the Bush administration. The Fed purchased more than $1 trillion in bad home loans that were packaged and sold as securities that no investors would touch. Quantitative easing was considered effective in slowing the economy’s decline. The rebound has yet to happen, however, with an anemic 2 percent growth rate in the third quarter. QE2 may be the only arrow left in the Fed’s quiver.

QE2 a ‘dangerous gamble’

Quantitative easing comes with high risk, and some are warning that runaway inflation could be the consequence if the Fed pulls the trigger. Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, recently called QE2 a “dangerous gamble” and a “bargain with the devil.” But grandstanding politicians demonizing government spending have deprived the Fed of fiscal policy in the form of economic stimulus. Economist James K. Galbraith told the New York Times that government stimulus would work. He said quantitative easing would do nothing but flood banks with more cash they won’t lend.

Sources

USA Today

New York Times

Bloomberg

Ben Bernanke's Fed has pumped nearly $2 trillion into the economy since 2008, to little effect. Image: CC Gage Skidmore/Flickr

Federal Reserve chairman Ben Bernanke has hinted that the Fed will begin another round of quantitative easing, known as QE2, to stimulate the economy. The mere possibility that the Fed will buy more Treasuries to pump money into the economy has devalued the dollar, lowered treasury yields, boosted stocks and raised the price of oil, gold, silver, corn and other commodities. Yet unemployment remains persistently high, which is the primary threat to economic recovery, according to Bernanke.

Bernanke says QE2 will prevent deflation

Having lowered interest rates to nearly zero, quantitative easing is the only arrow left in the Fed’s quiver to battle high unemployment. In a speech in Boston Friday, Bernanke said high unemployment is a scourge that could start feeding on itself by causing a debilitating cycle of deflation. CNNMoney.com reports that rather than focus on the Fed’s traditional mission to limit inflation, Bernanke said it was time to seriously consider that inflation is too low. In theory, quantitative easing — pumping more money into the economy — triggers inflation by weakening the dollar. The Fed has increased the money supply by purchasing nearly $2 trillion in assets since 2008, to little effect.

How QE2 has affected the economy

Investors expect the Fed to announce QE2 at its Nov. 2-3 meeting. The Associated Press reports that since Bernanke started hinting at such a move, anticipation of QE2 has profoundly affected the economy. The price of oil is up 10 percent. Americans are paying $400 million more per week for gas. Gold has risen 11 percent. Corn futures are up more than 30 percent. The average interest rate on a 30-year fixed mortgage has fallen to 4.19 percent, the lowest since the 1950s. The unemployment rate remained stuck near double digits.

Why QE2 isn’t likely to succeed

In Boston Bernanke justified QE2. In theory, the combination of a weaker dollar and low interest rates would increase spending, boost corporate revenue, create jobs and drive down unemployment. Kevin Giddis of Morgan Keegan, told CNNMoney.com that more quantitative easing won’t work because it hasn’t yet. “I don’t think buying securities is going to pull the economy out of a ditch,” he said. “The market is not buying it. We’ve made money available freely for a while now. The Fed has to start thinking way outside the box. This is not a war where conventional weapons can be used.”

A Federeal Reserve member said Japanese-style deflation in the U.S. economy is a possibility if the Fed holds benchmark interest rates at record lows indefinitely. Robbophoto/Flickr photo.

A warning that deflation could set in as U.S. economic recovery weakens was sounded by James Bullard, the president of the Federal Reserve Bank of St. Louis, Thursday. Preventing inflation has been the focus of Federal Reserve as it formulates policies to guide the U.S. economy out of the recession. But Bullard cautioned that Fed’s current policies to stimulate growth are putting the U.S. economy at risk of falling into a Japanese-style deflationary cycle that could keep the economy weak for several years.

Deflation could result from preventing inflation

Deflation is a widespread and prolonged drop in the price of goods, services, homes, stocks and wages. The New York Times reports that the Fed has been focused on preventing inflation. Starting in 2007, the Fed lowered the benchmark interest rate all the way to zero and pumped some $2 trillion into the economy with an array of emergency loans and purchases of government debts and mortgage bonds. To buy all those assets, the Fed essentially printed money — the $1 trillion in reserves. If the reserves were withdrawn and lent out quickly, the supply of money in the economy could increase rapidly, thus triggering inflation.

A recipe for deflation

The Fed quit buying government debt in March. Since then, the U.S. economic recovery has faltered and the threat of inflation is low. Bank lending is contracting. Big companies are sitting on piles of cash. Small businesses can’t get loans. The Fed’s reserves won’t be entering the money supply anytime soon. Unemployment is high. Home sales are at record lows and home prices are falling. The big picture has people like Bullard thinking ahead to the possibility of deflation.

Japanese deflation

Deflation started in Japan in the early 1990s. A 1980s real estate bubble burst, banks took a bath on real estate loans, restricted lending and asset prices fell. Cheap imports further lowered prices. The Bank of Japan and the government tried to eliminate it by reducing benchmark interest rates. The bubble’s collapse lasted for more than a decade with stock prices bottoming in 2003. Stocks went even even lower when the global economy collapsed in 2008. In November 2009 Japan returned to deflation, according to the Wall Street Journal. Consumer prices fell in October 2009 by a near record 2.2 percent.

Benchmark interest rate a ‘double edged sword’

Deflation warnings are being sounded by Bullard, a voting member on the Fed’s main policy-setting committee, as the Fed considers additional steps it should take to stimulate the economy if the weak recovery falls back into recession. The Associated Press reports that Bullard said the Fed’s pledge to hold rates at record lows for an “extended period” is a “double-edged sword.” The pledge could make investors, businesses and ordinary people think inflation could be heading lower, which could aggravate the risk of deflation. In addition to lifting the cap on the benchmark interest rate, Bullard said resuming the purchase of government debt should be considered to prevent deflation if their is a new shock to the weakened economy.