The Quantitative Breakdown

The President of the St. Louis Fed, James Bullard, claims that the benefits outweigh the costs of QE2, and that it the move will accomplish everything the Fed has set out to: Lower interest rates, prevent deflation and help kick start the economy.

 

First we’ll look at interest rates:

There are 4 basic interest rates relevant to the Fed: The Wall Street Journal Prime Rate (Taken as an average of 35 banks weekly as a consumer benchmark rate); the Federal Discount Rate (The rate at which financial institutions can borrow from the Fed; the Federal Funds Rate (rate at which institutions lend to each other); and the Treasury Bill interest rate.  The WSJ rate (lowering this would make credit much more accessible to consumers) is currently at 3.25%, already a low rate- and not a primary concern of the Fed (Bernanke has decided to take this approach in an effort to deal with unemployment and inflation as opposed to direct consumer spending increases).  The main focus of QE2 however is the Treasury bill interest rate.  The Fed is worried that demand for US Debt is declining, however 30 year US bond returns rose 34 basis points to 4.28% following the announcement of the new plan- this is as a result of increasing inflationary expectations and expected decreases in the interest rate.  In addition, lowering interest rates across the board will push investors to buy high yield bonds- putting more money into growth (theoretically).

 

Inflation:

QE2 is in fact an attempt to avoid deflation.  Bullard mentions the U.S. is trying to avoid falling prey to the deflation the Japanese encountered during the mid 1990s.  Japan’s economic policies at the time contributed to the stagnant period due to inflated expectations from its quantitative easing program.  In the early 90s, the Japanese government tried to keep the interest rates near 0%, which would in theory raise inflation rates.  This failed, however due to the conditions at the time (which are very similar to what the U.S. is facing today).  Bernanke hopes this round of quantitative easing will lead to an inflation rate around 3-4%, which could be enough to avoid falling prices and significant deflation.

 

Economic Benefit:

The potential effect of QE2 is currently highly debated.  While traders seem to indicate an initial confidence in the outcome of the Fed move, some economists remain cautious.  Robert E. Hall of Stanford University was quoted saying: “Bernanke is virtually pleading with the gods for inflation- but we’re not getting it”.  The government expects the low interest rates to raise employment rates by making U.S. exports more desirable, and thus more profitable.  This is one of the key differences between QE2 and traditional Federal Reserve approaches towards monetary policy.  Typically, the Fed will try to spur lending, however they cannot loosen restrictions banks have put in place to limit issuance of questionable loans.

The Bottom Line:

Years of questionable spending and lagging fiscal policy has forced the Fed to make a decision to deal with the impending deflationary tendencies the country is beginning to see.  In an effort to keep the American economy afloat, QE2 aims to keep inflation artificially above equilibrium, hoping to buy the U.S. system some more time to put a long-term solution in place.  This approach focuses on investors as opposed to consumers.  With increased investment (in fixed income assets), Bernanke is hopeful that consumer interest rates will remain low, but he has failed to realize the first roadblock consumers face when taking out a loan: institutional requirements.  Bank collateral and credit levels required to get a loan drive interest rates higher, as no bank will rationally make a low interest loan to anyone who does not qualify (in the aftermath of the sub-prime crisis).  Unless Bernanke can force banks to lessen their requirements, this approach is rendered moot.  Instead, the Fed is hoping simply to avoid stagflation (rising prices and increasing unemployment).  The Fed is bullish on the results of QE2, hoping it will lower unemployment by creating international demand for U.S. goods.  Economic recovery, after the release of QE2, is relying on the hiring of the increasing number of unemployed- either that will happen, or Bernanke is trying to buy more time.