Will QE2 Work?

The market has priced in quantitative easing by the Fed but the debate still rages on whether the central bank will be successful in stimulating the economy.
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(Poll updated with latest reports, statements from Federal Reserve officials.)

NEW YORK (

TheStreet

) -- With the

Federal Reserve's

policy meeting only a week away, mounting speculation on the central bank's likely move and its impact on the dollar, stocks and the economy is keeping investors on edge.

Stocks were trading in the red on Wednesday morning after the

Wall Street Journal

reported that the

Fed would phase out its bond purchase program to allow the central bank more flexibility to scale back its efforts should the economy recover or should inflation run out of control.

Stocks have rallied since the Sept. 21 FOMC meeting that first hinted at a possible move. The

SPDR Dow Jones Industrial Average

(DIA) - Get Report

and the

SPDR S&P 500 ETF

(SPY) - Get Report

are up about 4% each since.

The report expects the central bank to purchase a few billion dollars every month unlike the nearly $2 trillion purchase it initiated in March 2009. The market has been expecting the central bank to pump in anywhere between $500 billion and $1 trillion to boost the economy.

A more measured move may help the central bank navigate through relatively uncharted territory. There is little historical experience to suggest that quantitative easing will boost economic activity. It might also help get more hawkish Federal Reserve officials on board with quantitative easing.

Kansas Federal Reserve President Thomas Hoenig has been among the more vocal in his dissent. In an Oct. 21 speech, Hoenig, a voting member on the Federal Reserve Open Market Committee, warned against the danger of creating bubbles through excess liquidity. "There are real risks to quantitative easing," he said.

But in the last couple of weeks, more

Federal Reserve

officials have argued for the need for quantitative easing to boost the economy, as unemployment remains high and inflation too low. Their sentiment largely mirrored that of

Fed Chairman Ben Bernanke, who in his October 15 speech left little doubt that the central bank will resume the purchase of treasury bonds -- dubbed QE2 -- to stimulate the economy.

Vote: Will QE2 Work?

In an October 18 speech outlining the pros and cons of further quantitative easing, Atlanta Fed President Dennis Lockhart said he would be open to adopting a more "explicit inflation objective". "At this juncture, and given the circumstances of sluggish growth and measured inflation that is too low, I give greater weight to the risk of further disinflation leading to deflation. In my mind, QE2 is a form of risk management -- an insurance policy that is prudent to put in place at this time," he said.

Lochart also told

CNBC

that for QE2 to work, the size of purchases will have to be substantial. He expected $100 billion worth of monthly purchases of assets would be appropriate.

New York Fed President William Dudley suggested in early October that

further quantitative easing was warranted and that a $500 billion asset purchase program would have the effect of a half-to three-quarters basis point reduction in the federal funds rate.

In an October 19 speech, Dudley reiterated his earlier stance. "Viewed through the lens of the Federal Reserve's dual mandate -- the pursuit of the highest level of employment consistent with price stability -- the current situation is wholly unsatisfactory," he said.

Philadelphia Fed President Charles Plosser continues to be a strong voice of dissent. Plosser told reporters on October 20 that he thought the risks of further quantitative easing outweighed the costs, as he did not see deflation as a threat nearly as much as his colleagues. "I don't see the pay-offs for unemployment as very great and I don't see the necessity of it at this point given my forecast on inflation," Plosser told reporters, according to a

Reuters

report.

Monetary policy is about the only tool the Obama administration has to boost the economy. With more than a trillion-dollar deficit and economic activity remaining subdued, further government spending has become harder to justify from both an economic and political standpoint. The government has to lean on monetary policy to boost the economy.

The Fed would normally resort to cutting interest rates, but with the federal funds rate already near zero, there is little the central bank can do on this front. That leaves more non-conventional policies such as expanding the central bank's balance sheet through the purchase of long-term assets such as treasury securities.

Vote: Will QE2 Work?

But even the Fed is uncertain about the economic impact of such a move. "One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public," Bernanke noted on Friday. "These factors have dictated that the Federal Open Market Committee proceed with some caution in deciding whether to engage in further purchases of longer-term securities."

The Fed hopes that if it buys more treasuries, it could help temporarily depress long-term interest rates and drive investors towards riskier assets, stimulating investment and spending and thereby the economy. But mortgage rates and interest rates are already low and have failed to stimulate housing and business spending so far, as households and businesses continue to slash their debt exposure.

Monetary easing has failed to boost the economy because the U.S. is in a

"bona fide liquidity trap", according to Charles Evans, president of the Chicago Fed.

The Fed believes that consumers are saving rather than spending because their inflationary expectations are low. That hurts final consumer demand which in turn forces businesses to cut back on production.

In his speech, Bernanke noted that inflation levels were too low and inflationary expectations were likely to remain subdued for a while as the slack in productive resources constrained cost pressures. That was not a good thing, he argued. Low inflation expectations could spark the risk of deflation, where consumers stop spending because of expectations that prices would drop further, causing a further decline in the economy and wages.

Inflation rates currently hover around 1% while the Fed would prefer price levels to climb to its mandate of nearly 2%.

The Fed is now trying to actively communicate its objective to return inflation to normal levels consistent with its mandate and may allow inflation to even stay above its mandate of 2% in the short run. If consumers expect prices to rise, they would be prompted to spend more now in anticipation of rising prices. And with the Fed's bond purchase keeping yields low, credit will be freely available to fuel spending as well.

But critics say that while inflation can be stoked, it cannot be controlled. The Fed could be too successful in its efforts. If consumers spend more and the economy expands, prices could rapidly rise to unacceptable levels. Long-term yields would eventually climb as inflation expectations rise, hurting credit. The Fed may be forced to raise rates to cool prices, which could cause asset prices fueled by lower interest rates to crash.

Others worry that the Fed could completely fail in its attempt to raise inflationary expectations in the first place. Its massive quantitative easing would hurt the dollar, bidding up prices of oil and commodities that could hurt businesses, while doing nothing to stimulate housing and final product demand.

Meanwhile, the market has been rising in anticipation of the move, betting that the Fed would succeed. Any disappointments on the size of the bond purchase or the timing of the move could cause a pullback.

In light of all this, do you think the Fed will be successful with the next round of quantitative easing. Vote in our poll to find out what users of

TheStreet

think.

-- Written by Shanthi Venkataraman in New York

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