As I write this piece, the Federal Reserve is putting the finishing touches on a process called quantitative easing part two or QE2. This is the effort by the Federal Reserve to use monetary policy to get the economy growing faster.
It’s measured by the quarterly increase in the gross domestic product (growing at 1.6 percent annually as of the second quarter of 2010) and unemployment (now about 9.6 percent nationally). The two prior efforts at quantitative easing—QE1 and Permanent Open Market Operations—have been largely ineffective because the economic growth in the U.S. is slowing and our unemployment rate seems stuck just under 10 percent. So, after we know the results from Tuesday’s election, Ben Bernanke, chairman of the Federal Reserve, will announce the Fed’s course of action to hopefully spur the economy.
Just what is quantitative easing and why does this matter? In the past, when the economy slowed for whatever reason, the Federal Reserve moved to lower interest rates to make borrowing money cheaper for businesses and individuals. Ideally, this decrease in the cost of borrowing spurs borrowing and economic activity accelerates.
In 2008, the Federal Reserve essentially cut the rates for borrowing from banks to zero in an effort to spur the economy, but nothing happened. So the Federal Reserve moved to its next tool, QE1, to get things going. The Federal Reserve created $1.75 trillion, buying Treasury bonds and mortgages (from Fannie Mae and Freddie Mac). This action drove longer-term interest rates lower as measured by the interest rates for the two-year, five-year and 10-year Treasury bond yields. It also lowered mortgage rates for borrowers, for both new financing and refinancing. Here again, the notion is that by lowering interest rates, economic activity will pick up.
Permanent Open Market Operations was the second round of quantitative easing. The Federal Reserve took the principal payments from bonds and mortgages bought under QE1 and, rather than paying down the debt, used them to buy more treasury bonds and mortgages. Between QE1 and POMO, we have more than $2 trillion in stimulus efforts with very little to show for it. Now we are on the cusp of QE2 for another $500 billion to $1 trillion of stimulus. Will this finally get things going in the economy? Nobody knows. Basically the administration is in hope mode.
What are the consequences of these actions so far? If you pump money into the financial system, one of two things happens. Either the economy accelerates or asset prices increase. QE1 and POMO have resulted in higher stock and commodity prices in the markets and little increased activity in the general economy. The stock market has performed well, inflated by QEI and POMO. The Federal Reserve indicated in late August that it was readying QE2 and the market had a rousing increase in September, probably in anticipation of more money flooding into the stock and commodity markets.
I am not convinced that QE2 will do anything different from QE1 or POMO. Moreover, I am not convinced that the stock and commodity markets will head much higher based on this expansion of the money supply. In my opinion, these actions are not sustainable and are perpetuating some fairly severe consequences for the overall economy.
For example, our savers are getting stuck with interest rates so low that their savings are earning nearly nothing. What are retirees to do? If history has taught us anything, it is that inflation will eventually rear its ugly head as a result of the monetary expansion and we could have a recurrence of the ’80s, when inflation was double digits and treasuries paid more than 15 percent. That would be a disaster for a government as heavily indebted as ours is now. Furthermore, much of the business community is on hold, waiting for the economy to stabilize without federal stimulation.
What should investors do now? My recommendation is to pay close attention to developments in Washington, on Main Street and on Wall Street. The business of investing now looks like a minefield. I am more concerned with the return of your capital than the return on your capital.
Watch your step.
