Get ready for another round of Quantitative Easing (QE) by our Central Bank – The Federal Reserve Bank of the United States of America. Quantitative easing in essence is nothing more than a monetary policy tool used by central banks when the short-term interest rates, which they control, are at or near zero. The Federal Reserve Bank has a dual responsibility to ensure that our economy is functioning at full potential. They are legally bound to effectively promote the goals of maximum employment, stable prices, and moderate long-term interest rates. In other words, utilize monetary policy to stimulate economic growth and employment when the economy is “sputtering” or in recession, but make sure that inflation does not get too overheated so that it does not cause long-term interest rates to increase dramatically. It is a balancing act that is reminiscent of the “Goldilocks” fairy tale – not too hot, not too cold, but just right. However, if we return to the real world situation our economy finds itself in right now: unemployment at approximately 9.5% (with measures of underemployment above 17%), Gross Domestic Product (GDP) at 1.7% annualized for the 2nd quarter of 2010, and very low inflation of 1% and 0.8% (with and without the cost of food and energy) over the last twelve month period, we can see why the Federal Reserve may be motivated to ease monetary policy further.

If a central bank wants to provide additional stimulative monetary conditions by further easing of credit, it normally lowers the Fed Funds overnight rate that it charges banks within the system to borrow money. The banks in turn would make good use of this lower cost of money by lending it to creditworthy borrowers at a higher interest rate and make a marginal profit on the difference in rates. The borrowers would in turn either make capital investments with the loan proceeds or consume through the purchase of goods and services. Both uses of money would increase demand for goods and services and ultimately should increase the demand for labor and produce jobs. When that rate approaches zero or is at zero, how do they inject more money into the banking system? They buy assets. Typically, the asset purchases are the most liquid and highest quality assets one could buy: U.S. Treasury Notes. The money that the Federal Reserve uses to buy these assets comes from the proverbial “printing press.”  STOP THE PRESSES! Isn’t printing money inflationary? Doesn’t the Federal Reserve also have the responsibility of keeping inflation under control? The answer to both questions is yes. However, unless the additional supply of money finds its way out to creditworthy borrowers through the banking system, there’s little chance of it being inflationary. Ultimately, it is the demand for money from creditworthy borrowers that needs to create the “spark” that would rekindle economic growth and the potential for inflation.

In general, the equity and bond markets have been positively affected lately by the anticipation of further quantitative easing by the Federal Reserve Bank.  The equity markets typically appreciate when monetary policy is in an easing cycle because it is intended to stimulate the economy by lowering interest rates and promoting economic growth. The bond markets also react positively as interest rates decrease because this increases the market value of the future interest and principal payments associated with the bond. While these markets have been moving in the same direction of late, at some point they may begin to take different paths if the Federal Reserve Bank is successful in its effort to stimulate demand. While the equity markets are negatively affected by the potential for inflation, some companies may be less affected than others if their ability to grow profit margins is greater than the rate of inflation. On the other hand, the future interest and principal payments associated with existing bonds do not increase, they are fixed. So, if inflation pushes interest rates higher, the market value of most bonds will decrease. These two paths are by no means certain, and the timing is even less certain.

Even though the Federal Reserve Bank has not yet officially announced the second round of QE, the capital markets have already anticipated the announcement at the next meeting of the Federal Open Market Committee on November 3rd. The bigger question is whether it will work in doing what it is intended to do? From a purely technical and theoretical perspective, there’s no reason to doubt that it should work. However, based on past experiences of QE, it is less certain. In the first round of QE by the Federal Reserve Bank In March 2009, the Federal Reserve announced plans to purchase up to $300 billion of longer-term Treasury securities in addition to increasing its total purchases of GSE debt and mortgage-backed securities to up to $200 billion and $1.25 trillion, respectively. While we really don’t know whether the effects of QE were solely responsible for the improvements that followed in 2009 through the first quarter of 2010, we would be willing to credit QE with explaining most of what we saw during that period: Steadily improving private sector employment, (-744 thousand jobs in March 2009 to +241 thousand in April 2010), improving GDP (from -4.9% 1st quarter of 2009 to +3.7% in 1st quarter of 2010), moderate inflation (2.3% and 1.3% with and without the cost of food and energy) over the 12-month period from March 2009 to March 2010, and increasing interest rates (10 year Treasury Note yields increased from 2.6% to 3.6%) during the same 12-month period. However, it did not last, and the majority of members of the Federal Open Market Committee are sufficiently concerned about economic prospects and deflationary trends that they are contemplating a second round. There are doubters on the committee as to the effectiveness of another round of QE and whether it is worth the potential risks and unintended consequences of possible inflation or weakening U.S. currency. The only other longer term experience with QE was by the Bank of Japan from 2001 to 2006 (see our Fall Newsletter). The outcome for Japan was less than expected after 5 years of easy monetary policy. Japan could never really reverse the deflationary trends challenging its economy. The U.S. is not Japan, but many of the structural debt and political problems are similar, and so we are all wondering whether the outcome for the U.S. can be different than Japan’s.