QE2
On Wednesday, November 3, 2010, the Fed announced its second round of quantitative easing, affectionately known as “QE2” by purchasing another $600B in long term Treasuries over the next eight months. Quantitative easing can be simply defined as the government buying assets (i.e. T-bills, mortgages). The timing and size of the announcement was largely expected by many economists and again signals the Feds concern at the slow rate of economic growth and continued high rates of unemployment. An obvious question would be “why does the Fed need to engage in quantitative easing to lower interest rates?” The obvious tool for the Fed to lower rates is through the Fed Funds Rate. However, keep in mind that in December 2008 the Fed lowered this rate (the rate at which banks lend to other banks) to near zero and therefore the Fed can no longer use this tool as rates cannot go any lower. Remember that this new cycle of quantitative easing is called QE2 as the Fed has already tried quantitative easing before (around $2T during the recession), with mixed results. Here is how quantitative easing is supposed to work: The Fed buys assets from banks, driving down yields and interest rates. Consumers and businesses borrow in order to make purchases or expand businesses - economy grows - businesses hire more and unemployment declines. Consumers feel more comfortable spending more money and make more purchases - cycle continues. Low interest rates have another side effect – investors often place their money in riskier assets like stocks as they grow tired of earning extraordinarily low interest rates on their fixed income investments. Will this new round of quantitative easing work? The honest answer is that no one knows for sure. There are various economists and even some inside the Fed that don’t believe it will. What happens next if this round of quantitative easing isn’t more successful at driving economic growth? Clearly the Fed is out of ammunition as it relates to its conventional tool (lowering the Fed Funds rate) and will now have tried an unconventional approach (quantitative easing) for a second time. Congress could theoretically approve more spending, though there seems to be little appetite for that with the American public and in Congress. As it relates to fiscal policy, we may see the extension of the Bush-era tax cuts; however it is critical to remember that extending the tax cuts does not equate to new stimulus as it would simply be a continuation of where we are today. In contrast, a repeal of the Bush-era tax cuts could have further negative consequences in our drive for economic growth and stimulus. One of the main concerns surrounding quantitative easing is the inflationary environment it may bring in the short run, an idea the Fed seems willing to accept as they believe policies can be reversed fast enough if inflationary pressures were to spike. Please ask your RSM McGladrey, Inc. Wealth Advisor should you have any further questions. |
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