Why QE2 Won't -- and Can't -- Work

NEW YORK (TheStreet) -- QE2, to put it simply, does not address the fundamental problems the U.S. economy faces. It is preposterous to think that reducing medium-term interest rates by 25 to 50 basis points is going to lead to a significant increase in gross domestic product and a reduction in unemployment.

The package

After much anticipation, the Federal Reserve unveiled a second round of quantitative easing (QE2), or bond buying, two days ago. It wasn't a surprise. Market participants had expected $500 billion to $700 billion of bond purchases, and the Fed announced $600 billion. The purchases will happen on a regular basis through June 2011.

It works in the following way: The Fed will be in the market buying Treasury bonds mainly in the 5- to 10-year range. The $600 billion size means the Fed will be effectively buying most of the newly issued Treasury debt in this maturity range. This is in addition to the purchases being made with the income and maturing bonds from the first round of QE. That increases the amount of buying to about $800 billion.

The Treasury needs to issue debt to finance the sprawling fiscal deficit. The Fed buys the debt. It is added to the balance sheet as both an asset and a liability. In the end, the Fed's balance sheet will grow to a staggering $3 trillion, which is 20% of GDP. That puts the U.S. in an exclusive club -- second only to the 23% held by a country with a disastrous monetary-policy record: Japan.

The logic

Fed buying will increase the price of the bonds. Increased prices will reduce interest rates. There will be an indirect effect on other securities, such as corporate bonds and mortgage-backed bonds. Given that the Fed is buying such a large proportion of new issues, it is hoped that other fixed-income investors will shift some of their demand to mortgages and corporate bonds. This will increase prices and reduce interest rates. This will make corporate financing cheaper and presumably drive down the mortgage rate.

There is a secondary effect. As U.S. interest rates go down, the U.S. is presumably less attractive for foreign fixed-income investors. This may put downward pressure on the exchange rate. A cheaper exchange rate means exports are more competitive and imports are more expensive.