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Thursday, November 4, 2010
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".