The QE2 Update – Between a Rock and a Hard Place
Most of us know that the Fed can create an “Artificial Economy”, or prop the economy up by:
- Keeping the Fed Fund Rate low- (close to zero now).
- Pouring money into the economy to keep liquidity high.
The Fed hopes that by using these two tools they can jump start the economy and get it back on track. So far the Fed has spent over $1 Trillion dollars:
- Buying mortgage securities to stimulate lending and bail- out the banking system.
- Purchase Treasuries to keep interest rates low.
- To reduce unemployment by investing in infrastructure rebuilding and new construction projects.
After initial spending programs during the first half of 2010 called Quantitative Easing, (QE1), the Fed instituted a secondary spending program called QE2, which authorized an additional $600 Billion to be spend to get the economy going again. This money will be officially spent by June 2nd, 2011. Bernanke and company claim that this program has worked.
– Manufacturing output and jobs are up.
– Unemployment has dropped.
– Corporate and Bank profits are sky-high.
Problem #1– These are all good signs of at least a modest recovery. Here’s the problem. The money that is being spent by the Fed, is being printed with no security to back it. It is just adding more and more liability to what could be a $16 Trillion Deficit by year end. Could the Problems in Europe be a “Canary in the Coal Mine”, for what could happen in the United States. At some point you have to stop “Kicking the Can Down The Road” and address the problems that you have. Italy, Spain and Greece have already had their credit rating downgraded. So What? Think of each country as an individual with bad credit. They must sell Bonds to finance their debt, just like we do here in the United States when we sell Treasury Bonds.
If the risk of default increases, investors demand a higher interest rate, and it costs a lot more to finance your debt. Get the picture if we keep going down the road we’re travelling now, we could see the cost to fund out debt skyrocket, causing interest rates and inflation to sky-rocket as well. It’s already begun to happen in Europe. Could we be next? Moody’s has already begun to talk about downgrading U.S. debt.
Problem #2-What happens when the Fed stops spending the money? There are two possibilities:
- Like with the Cash for Clunkers program and the First Time Home Buyers Tax Credit Program, the gains may have occurred by stealing sales or productivity from the future.
Consequences-If that has happened, and the economy becomes weak again, the Fed is likely to introduce QE3, or spend more money by printing more money. That makes the scenario of inflation and higher interest rates very likely as the cost of funding the debt will rise. Remember, the Fed has pulled out all the stops to keep Treasury Rates and interest rates low. And, it hasn’t worked as both are still rising.
- The Economy is strong enough and doesn’t require additional spending to continue to improve.
Consequences- If the economy continues to grow, the Fed is likely to increase the Fed Fund Rate, or borrowing rate, which is what most other developed countries have already begun to do.
Consequences- If this happens, interest rates are bound to go up, reversing the modest gains that have been made in economic growth. If the Fed doesn’t increase rates, we are kicking the inevitable day of reckoning can (and the consequences of the same) further down the road. If the Fed raises the rates too quickly, we could be delay economic recovery well into the future. That’s why most experts are estimating a full recovery won’t take place until at lest 2014.
And you thought that the outcome of your favorite TV show was a Thriller. You can’t help but to stay tuned for what will be next for the U.S.