What Could Go Wrong With QE2

On Wednesday the Federal Open Market Committee (FOMC)—the policy making body of the Federal Reserve—announced it is directing the Fed to buy $600 billion in Treasury bonds over the next 8 months. Since Fed Chairman Bernanke is convinced Congress isn’t going to stimulate the economy, he has taken matters into his own hands. So, what exactly is the Fed doing, why, and what are the projected implications of this activity?

Quantitative easing (QE) is basically a monetary policy tool for expanding currency in circulation in order bring down long-term interest rates. Typically, the FOMC can just change the Federal Funds rate to manipulate interest rates, but with with that rate already basically at zero, the Fed has to take another tactic. The Fed already engaged in round of QE starting in 2009 with the announced purchase of $1.25 trillion in mortgage-backed securities from Fannie Mae and Freddie Mac and $50 billion in government debt.

The goal of QE2 is to lower long-term interest rates so that homeowners can more easily refinance and investors can borrow at lower rates to purchase assets, driving up asset prices. Furthermore, by buying government debt, the Fed will push down the yield on investing in Treasuries, meaning banks could need to look elsewhere for a return on investment, such as lending into the private sector or buying stocks—and that would mean more capital for business to work with and cheaper loans for small businesses. And on top of that, the expanded currency (aka, inflation) will weaken the dollar and help U.S. exports.

If it works, it is a much prettier picture for the economy. But if it doesn’t work, there are some severe unintended consequences we may have to deal with—not the least of which is out of control inflation. Here are a few reasons QE2 might not work:

First, many are skeptical that QE2 can lower interest rates enough to have the targeted success. The goal is for interest rates to move 20 to 50 basis points (ex. from 3.75% to 3.55% or from 2.80% to 2.30%), but it is not at all clear that this is what the economy has been waiting for to take off. For example, homeowners are already flocking in droves to refinance. A lack of equity or cash on hand to afford a modification, the backlog of banks in working through all the refinancing paper work, and Foreclosure-gate are bigger reasons that refinancing has been slow.

Second, the problem isn’t really a liquidity problem. It never really has been. Its been a confidence crisis and balance sheet crisis since the start. There is a lot of money in the system now. More than double the typical reserves held by banks, and some $1 trillion held by corporations waiting to invest. But if investors fear taxes, regulator burdens, or populist backlash, they won’t invest. If companies want to work down their debt and banks want to stabilize their balance sheets, they won’t invest. If there are fewer qualified borrowers in a chastened economy that still has a massive hang over from its debt binge, there won’t be investment. Throwing money at the problem doesn’t fix these things.

Third, the monetary expansion (literally creating money out of thin air, changing the numbers on a computer account, and printing the cash to back it up) is inflating the value of the dollar. On the one hand, this does help exporters in the short term because it makes American goods cheaper and easier to sell. However, it also means that investors get less of a return on their investment dollars because the value of the dollar relative to other currencies is shrinking. Put another way, if you invest in the U.S., the value of your profits will buy less goods elsewhere because of inflation. This means less investment in the U.S. and that means… less JOBS.

Finally, while the first round did keep interest rates low, it didn’t spark a massive recovery. Since this is less money than the first time, the skepticism around QE2 is healthy. And that is not to mention that rates are already at historic lows and it is very possible QE2 won’t hit the minimum goal for moving interest rates Even the Fed knows it is rolling the dice here.

And given the very real danger of inflation crushing the economy in the future, this is a dice role that wasn’t wise to make.

Update: Here is another good summary of QE2 that is coming from a more objective stance if you want to take away my two cents.