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Thursday, November 4, 2010

What Is Quantitative Easing?

Yesterday the Federal Reserve, accompanied by considerable hoopla, announced a $600 billion "quantitative easing" (QE)program. This is actually QEII. After QEI, the stock market moved higher; so understandably some are happy. The job market? Not so much.

To understand QE, it is helpful to review normal Federal Reserve policy. Typically the Fed targets the federal funds rate. This is the rate at which banks lend each other reserves. Banks are required by the Fed to hold reserves versus deposits. The federal funds rate affects other short-term rates. Longer term rates are typically influenced by inflation expectations - not the Fed.

As it has turned out in the current business cycle, the targeting of the fed funds rate is no longer an option for improving the economy because the Fed has pushed it to practically zero, with zero results. In other words, the Fed lowered the rate to practically zero; and we still have unemployment close to 10% with the possibility of further job market deterioration.

QE is a different policy from targeting the fed funds rate. Instead of targeting a short-term interest rate, QE commits a certain amount of money to buy longer maturity bonds. It will impact longer term interest rates. Yesterday the Fed announced a $600 billion QE program.

Here's the thing to get: the Fed creates money out of thin air. Think about this - if you want to buy my house, you have to get the money from somewhere. You have to get it from your savings or borrow it from somewhere. Not so the Fed. It just writes a check. What backs the check? Nothing. It is what is called "fiat money" - money by declaration. Money is literally created out of thin air.

Yesterday I posted a video where people were interviewed asking if Obama was a Keynesian. The responses were pathetic. Some thought the question was about if he was from Kenya. Along the same lines, if you asked people if gold backs the nation's money supply, most would say yes. The American people have no idea how Federal Reserve policy works. This would require an understanding of our basic economic system - something our leaders in education haven't deemed important.

Anyways, when the Fed buys bonds, the check is deposited and, thereby, the amount of money in the economy is increased. Banks can lend the excess reserves created by this transaction, and the amount of money in the economy would go up even more. This is what the Fed is hoping for but hasn't occurred yet.

This process is called "monetizing the debt"." And there is a lot of debt out there. It is the equivalent of running the printing presses to print money.

Why is the Fed buying bonds? After all, they could put money into the economy by buying anything - used cars, for example. They are buying bonds because it is a way to control longer-term interest rates - like the rates on mortgages, for example. They've come to the end of the line on controlling short-term interest rates; now they are after longer-term rates. In other words, they are now controlling the price of short-term money and long-term money.

QE is just another step on Hayek's "Road to Serfdom".


  1. So in essence, the Fed now will print money to buy as much as $900 billion in U.S. government bonds through June — an amount roughly equal to the government's total projected borrowing needs over that period.

    Do you think the effect of this will be to drive up inflation and interest rates, and ease pressure on the government to lay off the reckless spending? I see precious metals are up even more than the stock market today.

  2. "Yesterday I posted a video where people were interviewed asking if Obama was a Keynesian. The responses were pathetic. Some thought the question was about if he was from Kenya. Along the same lines, if you asked people if gold backs the nation's money supply most would say yes."

    And these people vote? :S
    Some commentary:

  3. In MHO the Fed is walking a tightwire with the $ imploding. Any protest at all by the countries that soak up our debt will cause rates to skyrocket. Maybe the Fed thinks it can pick up the slack - after all a blank check can make one feel powerful I guess.
    I'm not sure why the rest of the world is so willing to buy Treasuries. The rates are pitiful and they are losing on the currency.

  4. Robert,

    I'm in agreement with you that this is a VERY dangerous game. I really don't understand all the arrogance out there. Do we actually think that we can continue along this path? I find it equally arrogant that we always claim that any country that doesn't play their cards the way we like as playing the currency game. In some cases this is true, but what about our own currency game? We have to get control of our spending. These spending habits put us at risk.

  5. Rob, there is 1 positive side to QE2: it will make US exports more price competitive in global markets. Obviously, in the end someone has to pay the bill!

  6. The whole idea that export are gogin to be more competitive is interesting.
    What the guys above me forget, is what does the US exports today?? T-Shirts, computers maybe.
    The only companies that are exportign todays are industries supported by the government, such as boing and GM, for other small business who used to export but are not anymore, a higher or lower dollars doesn't make a difference.

    And finally, American companies are jsut not willing to export, as it takes to prospect foreign markets, go to different countries and maybe speak a different languages, all things that Americna are either too scared to do, or not enough educated to understand the process.

    With 600 billion in my pocket, I'll buy the best teachers in the world!!!not morgages.