The day after mid-term elections, the Federal Reserve, led by its Chairman Ben Bernanke, announced it would buy $600 billion of US government bonds (treasuries) during the next eight months. Quantitative Easing II (QE2), as it has been termed, essentially means that the US government is going to print dollars in order to buy its own debt.
The goal? To lower interest rates in order to facilitate borrowing and growth. Unemployment has been hovering above nine percent, and the US economy is not recovering as quickly as the Fed had hoped. QE2 is the Fed’s unconventional last-ditch effort at dealing with the problems that the stimulus package and subsequent efforts couldn’t fix.
According to Bill Gross, manager of the largest bond fund in the world at Pacific Investment Management Co., QE2 could result in a serious depreciation of the value of the dollar by 20 percent. In other words, if you have 100 dollars today, it would only be worth 80 dollars in next couple of years. This would be a severe blow to the purchasing power of the dollar, making it more expensive to buy groceries, clothes, and other basic goods.
QE2 and the Federal Reserve policy of keeping interest rates near zero have made it nearly impossible to generate income through savings accounts or other low-risk fixed income vehicles. As a result, consumers are incentivized to make riskier bets in stocks, pushing the stock market ever higher.
In the days following the Fed’s announcement of QE2, the S&P 500 reached its highest point since 2008 before Lehman Brother collapsed and the recession hit. The soaring stock market, however, does little to quell concerns that inflationary fears could cause long-term interest rates to move higher and essentially accomplish the exact opposite of what the Fed intended.
The reason for purchasing treasuries is the relationship between treasuries and the borrowing rate of the general public. On a bond, price and yield have an inverse relationship. If the price rises, the rate will lower. This is the rate you will have to pay when you borrow from a bank.
Banks make money by borrowing from the government and lending to the general public. For example, the Bank of America can borrow one million dollars for 10 years at two and a half percent. Then, they lend this money to the consumer at a rate of seven percent, who uses it to buy a house or start a business. The Bank makes three and a half percent on the transaction. The lower the rate, the more incentive they have to lend to you, the public.
While this logic is sound in theory, it is not practical in the current market environment. In the early 2000’s, interest rates in the US were very low (much like today), and there was extreme political pressure for banks and other institutions to make loans. For instance, groups like Acorn pioneered lawsuits to force banks to give loans to people who could not reasonably be expected to pay the money back. When this pressure was coupled with the lack of regulation (no required verification that the person seeking a loan was employed), it led to an extreme amount of lending to unqualified people.
In the end, these people could not pay back their loans to the bank, and the banks got burned. Banks have learned their lesson from this history, and instead of circulating this money through loans they are hoarding the cash to protect themselves. They are refusing to lend to anyone without a spotless credit report.
In the end, profit is the bottom line and this is what QE2 attempts to bolster. By purchasing $600 billion in US treasuries, the Fed will drive down interest rates in the hopes that this will convince banks to lend (but as I’ve said, with the new higher credit standards and the memory of what making risky loans can do to them, banks likely won’t lend.)
Similarly, market commentators point out that businesses have cash on their balance sheets that could be used for hiring new employees. Why aren’t these businesses hiring the employees that they could? Why aren’t they expanding? Because they are businesses, and their goal is to make money. If they hire more people, they could actually end up losing money.
With the passage of the healthcare bill, businesses fear being crippled by the cost of hiring more than 50 employees, at which point they could be required to provide health insurance for all their employees. Businesses could actually lose money by expanding, so there is no incentive to do so.
While the Fed’s move has seen support, President of the Federal Reserve Bank of Kansas City Thomas Hoenig voted against the Fed’s monumental decision, referring to it as “a deal with the devil.” By having the Fed attempt to prop up the economy with QE2, a divided Congress and the Obama administration according to some face less pressure to address the underlying cause of the economic downturn: long-term deficit problems. Until we begin cutting expenditures and reigning in unwieldy government spending, the economic recovery will remain muted.
Kathleen Donahue is a Notre Dame alumnus and Executive Editor Emerita of The Rover. Contact her at kdonahue23@gmail.com.
