QE stands for quantitative easing. The Fed, or central bank, is looking to inject $600 billion over an eight month period into the economy using this method. This will be the second round of quantitative easing, hence the 2. The intent is to stimulate the economy by lowering interest rates to increase lending and spending.
Here’s how it works. The Fed buys treasury securities from banks and other institutions. Now, the banks have extra cash on hand. They can do a few things with this new money.
- Banks are required to hold funds in reserve in case of a run on the bank and to help prevent default. Some of this new money is required to be held in reserves.
- The rest of the money can be invested in a number of ways. Banks can continue to shore up their reserves, make capital expenditures, hire new employees, expand business, or lend it to businesses and consumers. This lending, which is the business of banking, helps inject money into the economy, promoting growth.
However, Andrew Crezscenzi, senior vice president and market strategist for Pimco, has a different view. Evan Simonoff’s FA Blog states “What's really happening in Crescenzi's view is that as consumer and corporate deleveraging continue, the money supply is barely expanding, loans are contracting and money is ending up back at the Fed, which is simply trying to recycle the money back into the real economy.”
Now, once the banks have this extra money, the question becomes: will they really lend it out, helping to easing the current credit crunch? I know if I had an extra chunk of change, I would pay off my debt first, then be sure I had plenty of savings for bad times, and finally I would invest cautiously. If banks do the same - take care of their own house first, and lend money last, then economic growth resulting from QE2 is likely to be small and slow.
Another question: what happens when you add more money into the economy? There are more dollars chasing the same amount of goods, so the dollar becomes worth less. This can mean that it will cost more money to buy the same things as before, and that is inflation. Current predictions are that the prices of commodities such as corn and cotton are going up next year, causing the cost of groceries and clothing to increase. Combined with the current unemployment rate, increased inflation can only hurt consumers, causing them to pinch pennies and hold back on purchases, stifling growth. However, if Mr. Crezscenzi’s view is correct, the same money will be circulating in the economy, not new funds, so inflation would not be as big of a concern. The economy would have room to grow.
So, will QE2 work? In theory, it works well in the near term to help stimulate spending and hopefully create jobs. Cheaper dollars may also work to our advantage by increasing US exports, thereby increasing the demand for our goods. But this policy can create inflation and instability in the markets long-term. The Fed may be to use the QE2 as a debt reduction strategy by monetizing the national debt. This is a process of reducing the value of the dollar, through inflation, so that we pay down the expensive dollars borrowed with cheaper dollars.
I can’t predict the outcome of our current economic policies, but I encourage you to be alert for changes in this policy so you can be prepared to update your own financial plan as needed.