New Name for an Old Solution

New Name for an Old Solution

I will readily acknowledge that if I was the only man standing in the room with Ben Bernanke, I know who the smartest man in the room is, and it is not me.

Having said this, I am wondering about “quantitative easing”. What is this new technique that the Federal Reserve has come up with to solve our economic pains.

The Federal Reserve is charged with several functions. “Today, the Federal Reserve’s duties fall into four general areas:
• Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
• Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the rights of consumers
• Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
• Providing financial services to depository institutions, the U.S. government, and foreign official institutions including playing a more role in the operating the nation’s payments system.” [1]

I am not saying quantitative easing is not within its powers, but I will state that eventually Quantitative Easing has to be inflationary. In the end, the Fed is simply creating money which it then uses to buy government bonds and other financial instruments.

In this instance, we must hope it results in improving liquidity and spurring investment.

It is the case that many companies are as lean as the care to be. They have cut costs, laid-off workers, and shuttered inefficient operations. The result is corporate America is sitting on a chest of cash, ready to invest in an expanding economy.

In my mind, the issue is that our economy has become primarily a consumer economy and consumers are tapped out – they are still overextended with debt and for the most part sitting on the sidelines. This is an intelligent move. For years, many lived off “paper equity” in their homes. When we needed a new car, we borrowed against our house, and purchased a car.

Now, housing prices have fallen and many homes are not worth the debt that has been accumulated to fuel this consumption-based economy of ours.

Typically, the Federal Reserve would lower interest rates to encourage spending and “pump” the economy. However, the discount rate is already at or near 0%, and rates cannot go lower.

The result is that the Federal Reserve has implemented a round of Quantitative Easing (and, it should be said – since this initial posting, they have implemented a second round QE-2).

One interesting outcome of this policy is that we are essentially “sending the bailout bill” to anyone who is holding large quantities of US Dollars. In other words, this is one way to resolve the currency issue with the Chinese who have been reluctant if not slow to let their currency float. Now, with QE-2, the dollars they are holding with be less valuable.

In the near term, it will also be interesting to see what effect this has on:
1. Gas prices and other commodities – one could expect we will end up paying more at the pump
2. US Liquidity – will it be easier to get a loan and will banks become more aggressive in their lending practices.
3. Yields on government bonds should be depressed (which, one would think would make borrowing cheaper), which may encourage investors to seek higher investment returns in other investments.

Call it what you will, but in the long-term, this policy will most certainly be inflationary.

Notes:[1] “The Federal Reserve System: Purpose & Functions”, Board of Governors of the Federal Reserve System, Washington, D.C., Ninth Edition, June 2005.