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.
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.
Select the service that is right for you!COMPARE ALL SERVICES
Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV