Federal Reserve’s $600 billion buybacks unlikely to stimulate economy

This week, the Federal Open Market Committee (FOMC) met to discuss a plan to add more long-term Treasury securities to the Federal Reserve’s balance sheet, in a move known as “quantitative easing,” or as those familiar with it dub simply “QE2.” The Fed already engaged in quantitative easing after the beginning of the financial crisis, aiming better than a trillion at markets for short-term interest rates.

The rationale behind the plan is simple enough. The Federal Reserve creates money, out of thin air (see: fiat currency system), then goes out and buys some form of financial asset like government bonds or other forms of debt, adding an amount of excess bank reserves to the whole banking system. In this case, the amount is $600 billion. Banks then are supposed to take the money they’ve received from the Fed purchases and lend it out, creating ‘new money’ and thereby stimulating the economy. Another important use of QE is to keep an economy out of a deflationary situation – that is, the opposite of inflation, a fall in both prices and wealth.

Quantitative easing was used unsuccessfully by Japan at the beginning of the last decade to try and prevent deflation. Still, some experts believe that Bernanke’s fast action to buy mortgage-backed securities and other debt at the start of our financial crisis has been a prime factor in keeping us out of an even bigger deflationary vortex. You can pin the medal for saving your parents 401k plans on him in all likelihood, or at least he can split it with Obama for the stimulus. 

Nonetheless, a lot of people are asking why the Fed has decided to commit to these buybacks. In a highly unusual move, Bernanke directly addressed the public in an Op-ed, run by the Washington Post. “The job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.”

Out of this, we can at least garner that Bernanke believes that prolonged unemployment is becoming an issue that may transform into something much worse for our economy. He goes on to mention that while inflation is low, if it is too low for too long it risks transforming back into deflation, in the form of falling prices and wages. He furthermore believes that the Fed has a lot of room to push more money into the system, due to the lack of a return to growth.

Some critics have argued that interest rates simply can’t go any lower and that banks aren’t going to lend when they can gain some interest on reserves and the economic climate is weak. Banks in turn, might tell one that demand for loans is extremely weak at present. So banks won’t lend because no one is asking, and people won’t take a loan because the economy can’t support their idea for a restaurant. Sounds something like a catch-22.

What is sure to happen as a result of QE2 is pretty simple – more U.S. dollars in the system will make all of yours and mine less valuable. This is good for U.S. exports and some other markets, but in all likelihood we will be taking another hit at the pump. Oil prices are a broad measure of inflation and follow it closely. However, if you’re thinking of getting a 30-year fixed rate mortgage any time soon, those tend to follow long-term Treasuries – exactly what the Fed will be spending the new money on.

One senses this much about the move – in the very short term, it may help stock prices, and even make companies a bit more apt to hire new employees and expand business operations. However, the Federal Reserve’s mandate is to stimulate economic growth and keep inflation low, and all this money eventually will need to be soaked up out of the system. In the middle of both of these, we have the real economy, which refuses to wake up no matter how much the government or the public poke and prod at it. On the whole, this extra round of quantitative easing might be enough to keep us from being another Japan for now, but it is certainly too small to bolster any kind of major impact on the economy any time soon.