Fed’s QE2 offers cause for concern
On November 3, the Federal Reserve announced Quantitative Easing (QE2), a plan to purchase bonds in order to force interest rates down. The Fed will buy up to $600 billion of intermediate and long- term government bonds between now and June 2011. The numeral “2” is present in the title because the Fed initiated the first round of QE in 2008 in the midst of the financial meltdown, a situation very different from today.
Chief among the Fed’s reasons for QE2 is that the agency believes lower interest rates will spur economic activity in the form of home buying, corporate investment and consumer spending.
The Fed already has forced short-term rates to near zero so it now believes longer term rates should be forced lower as well. The Fed sees the economy as too weak, unemployment as much too high and inflation being too close to zero for comfort. Most investors would agree with the first two concerns, especially as it relates to unemployment. In fact, balancing the right levels of inflation and unemployment is the Fed’s mandate. Yet it is not high interest rates that have resulted in massive job losses since 2007.
Many interest rates are already lower than they have been in decades and there is reason to doubt that another ½ percent drop in rates will move the unemployment down sharply from its 9.6 percent level. Businesses are reluctant to hire for a variety of reasons, including taxes and regulatory matters. High interest rates do not appear to be a main concern.
While the Fed is right to be concerned about the possibility of future deflation, there should be less concern about very low inflation. Inflation is currently running in the 1-1.5 percent range, modestly below the Fed’s desired target of 1.5-2 percent.
This difference may not be enough to warrant QE2. At this point, the most important concern should not be with QE2’s intended effect, but with the possibility of serious, unintended effects. Chief among the unintended effects is that inflation mounts a comeback to a level even the Fed does not want. This is probably not an immediate concern as most markets are not forecasting high inflation at this point. However, sooner or later the Fed will want to stop buying bonds and start selling. If this reversal is not well-timed, inflation could become a serious problem quickly.
A second primary concern is that it was excessive borrowing that got us into this mess in the first place. Lowering interest rates to encourage more borrowing may be a little short-sighted. Right now, consumers appear to be trying to get their financial house in order and work down their debt loads. That seems like a sensible move, especially as many baby boomers are trying to financially prepare themselves for retirement.
Lastly, there is a fear that the Fed’s actions will simply push down the value of our dollar versus other currencies, causing serious trade disruptions with our partners and hurting consumers and savers alike here in the U.S. Low interest rates have been good for borrowers and not so good for savers. Likewise, a falling dollar may be good for exporters but not so good for consumers.
Let’s hope the Fed is successful and its actions are well-executed. The consequences of failure are not attractive.