Quantitative Easing

by Sergio Mariaca on Aug 1, 2011 4:24:00 PM |Share:

economic growth quantitative easing bond-buying deflation

  As we’ve already mentioned, the Fed’s controversial $600 billion bond-buying program known as Quantitative Easing, or QE2, ended on June 30th with mixed opinions about its success. Quantitative Easing pumped money into the banking system through the purchase of approximately $1 trillion in Treasury securities, which in turn gave banks abundant funds to lend out to businesses and consumers. The Fed officials hoped it would prevent very low inflation from giving way to a Japan-style bout of deflation—this occurs when the overall consumer price level decreases, dragging the economy down with it. The Fed also sought to stir the economy by holding down long-term interest rates, which in turn would hopefully boost prices for stocks, corporate bonds and other financial assets. In addition, they believed more job growth would follow.

Although the Fed succeeded in putting deflation worries to rest, economic growth is slower now than what it was when the program was enacted last year. Although stock prices are higher and corporate bond yields lower, prices for oil, grains, and other commodities have surged, pinching many consumers.

While analysts and investors debate whether the end to the bond-buying effort will have a significant impact on financial markets, the Fed faces a major decision:  when to start draining the excess credit out of the economy by raising interest rates. Many investors are also worried that interest rates will rise now that the Fed has stopped purchasing treasuries, which amounted to about 85% of government debt sold by the Treasury since the program started in November, 2010. Who will replace the Fed as a new buyer now that QE2 is over?  (Source:  WSJ April 25, 2011)  

If the demand for government treasuries is not enough to replace the Fed, it is very likely that interest rates will go up, which in turn could cause even more problems for the real estate market and additional costs for everyone involved, especially for mortgages and the deficit.  

Unfortunately, a number of economists predict that the financial markets and the economy still are not strong enough to stand on their own. They argue that the economy, job markets and asset prices might stumble. If such a significant weakening of the economy does occur, that might force the Fed to buy Treasuries again to prop up the markets:  Enter QE3. It is still very questionable whether or not the Fed would need to initiate a third round of quantitative easing because such a program would be dependent on a significant weakening of the economy.  (Source:  WSJ April 25, 2011)

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