The Federal Reserve announced a plan to buy $600 billion in government debt with the intent of driving already low interest rates lower. The central bank will buy back debt $75 billion a month through next June. This latest round of quantitative easing is referred to as “QE2” because it follows the first round of quantitative easing when the Fed spent $1.7 trillion buying government debt after the collapse of the economy at the end of 2008 through earlier this year. The problem – nobody knows if it will actually work.
Here is how it is supposed to work. The Fed buys Treasury Bonds from banks. This provides banks with cash to lend to customers. At the same time, buying a large amount of bonds lowers interest rates because demand for Treasury bonds leads to higher prices and lower yields. Lower rates entice businesses and consumers to take out more loans. As an investor, lower yields make bonds, CDs, and money markets less appealing. Therefore, businesses will buy equipment while individual investors pour money into investments like stocks. As stock prices take off, consumer confidence rises and businesses see a rise in sales which leads to hiring. Many economists call this the “wealth effect”. People who feel wealthy, spend more.
There are dangers associated with quantitative easing. It has the potential to make a weak dollar even weaker which can lead to currency disputes with other countries. A weak dollar can help companies that export goods. However, it can make imports like fruit more expensive to the American consumer. Many experts also speculate that quantitative easing will lead to wild inflation or may create asset bubbles as asset managers leverage cheap debt to buy speculative investments.
History will be the judge of the effect, if any, of the Feds second round of quantitative easing. As the old saying goes: only time will tell.