Speculation is rife that the Federal Reserve is about to embark on a second round of so-called quantitative easing or QE2 as the media calls it. One of my readers asked me today what this really means. QE2 is a program by the Fed of buying treasury bonds. In other words, the Fed prints up more goes into the bond market and buys government bonds. this has two immediate effects: it lowers the interest rates on the government bonds and it increases the money supply. Let's look first at interest rates. The bond market sets rates based upon the demand for treasury instruments. the more demand there is for treasury bonds, the lower interest rates will go. So if the Fed steps in and buys 100 billion dollars of treasury bonds, there will be a marked effect on interest rates. Right now, short term rates are about as close to zero as possible, so the purchases by the Fed will most likely be in the longer maturities like ten, twenty or thirty years. So the Fed will be able to use QE2 to bring down the ten year bond to 2% or the thirty year bond to 3%.
At the same time that interest rates fall, the money supply will soar. why is that? In simplest terms, the Fed gets the funds to buy these bonds by printing new currency. If you look at your US currrency, you will see that it consists of Federal Reserve Notes. These are promises to pay by the Federal Reserve Bank, so the Fed can simply print more cash and use it to buy the bonds. Of course, each time the Fed prints more money, it increases the money supply. Using QE2 to buy a trillion dollars of government bonds would increase the money supply by a massive percentage.In 2009, during the first quantitative easing, the Fed essentially doubled the money supply. An increase of another trillion dollars would raise this newly inflated money supply by more than 50%.
So what is the effect the lower interest rates that would result from QE2? first, it would probably make all long term interest rates go down. that would let corporations and state and local governments borrow at lower costs as well. This would reduce the squeeze on the state and local governments to a small extent. It would also allow businesses to borrow at a lower cost to hopefully expand and hire new people. It would also lower mortgage and car loan rates. That is the good side. On the other side, the lower long term interest rates would reduce the income of those who live off of interest income, principally elderly retired folks. These people have already seen their money market and CD returns plunge to near zero rates. QE2 would send corporate rates lower as well, further reducing the income of this segment of society. there is no reliable data that can predict the change in consumption by these folks that will result from their losing a still greater part of their incomes as interest rates decline. Then there is the issue of whether or not lower long term rates would actually stimulate the economy. Right now, corporations are sitting on a huge pile of cash and are not investing due to fears about future demand; there is no shortage of funds to borrow at current rates. Further, mortgage rates are at historic lows and housing purchases seem unaffected by the low rates. Is there any reason to believe that even lower rates will jump start the housing market?
And what is the effect of an exploding money supply? Economic theory says that if the money supply increases too fast, there will be a big increase in inflation. The old description of inflation as too much money chasing too few goods explains why. If you increase the money without increasing the goods produced, you get inflation. So why, you may ask, have we not seen inflation as a result of the first quantitative easing? the answer lies with something called the "velocity of money" or the speed with which money travels through the economy. Because of the recession, many folks took their cash and saved it at much higher rates than before the recession began. So as the Fed added money to the system, the people stopped it from moving by putting it into savings rather than spending it. In theory, however, as the economy recovers from the recession (assuming it ever does), people will take their savings and return to old consumption patterns. That will increase the velocity of money which, in turn, will lead to higher inflation.
In the 1980's, the money supply was watched carefully to see if it had increased by an extra percent or two which could cause inflation. the stock market gyrated with each report of the money supply due to fear of inflation. With QE2 in place, we could see a money supply that is three times higher than that which was in place at the start of the recession. Just imagine what kind of inflation will result. We may be seeing inflation of the sort that only appeared in 1920's Germany and certain third world countries that have had economic melt downs.
Given these outcomes, you may wonder why the Fed would undertake QE2. I have to say that I wonder the same thing myself. There may be some short term benefit for the economy to the lower interest rates, but the long term dangers are enormous. Of course, there is one long term result that may be the Fed's goal in all of this. QE2 allows the government ot monetize the federal debt. In other words, instead of paying back the debt by taxing folks to raise the money, the government will merely print up some additional money and sent it out to the bond holders. this will take the pressure off the federal government for a year or so with regard to the debt. It will, however, make the holders of US debt more than a little nervous. Imagine the Central Bank in China that holds a trillion dollars or so of US bonds. Would that bank want to keep holding those bonds and even buy more if it suspected that the dollar would soon collapse due to increased US inflation? The answer is no. So That means that as the Fed increases its purchases under QE2, there will come a point where other potential purchasers of treasury bonds will pull back and leave the market. At that point, the Fed will have to continue to print more money and buy bonds or interest rates will soar. (Remeber that in 1981, interst rates hit levels just under 20% in order to stop the runaway inflation left by the Carter years.)
Some of what I am describing is bleak to say the least. It may never come to pass; however, under the generally accepted economic theories it should. Let's hope the Fed thinks better of QE2 and decides to leave things alone.
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