On 11/3/2010 the United States Federal Reserve announced that they are going to spend 600 billion dollars to purchase short term treasury bonds. Fed will buy $75b a month through June. On Oct 28, 2010 Bloomberg reported that the Federal Reserve had surveyed bond dealers for forecasts regarding how much asset purchases they expect from its second round of quantitative easing (QE2), and how much they expect such purchases to effect the market. I think they were better off if they just write a blank check to the Wall Street.
The Fed has re-embarked on a policy of quantitative easing. Its first round of quantitative easing, QE1, started in November 2008 and ended in March 2010.
What did Fed achieve by QE1?
The Federal Reserve purchased $1.25 trillion of agency mortgage-backed securities (MBS) and about $175 billion of agency debt. With QE1, the Fed's newly printed dollars were used (for the most part) to purchase illiquid assets such as mortgage backed securities from the large commercial banks. The cash received for these securities is being held on deposit at the Federal Reserve Banks. What all of this means, however, is that in essence, QE1 created very little velocity of money because the cash created in the first program did not move through the system. On the other hand due to absent of Mark-to-market accounting rule Fed over paid MBS and banks pocketed huge sums of money. Oh yes! they did it.
What does Fed hope to achieve by QE2?
Indeed, I'm not sure that the Federal Reserve or anybody else fully understands how quantitative easing works. The typical explanation between economists is that the Fed's purchases of longer-maturity securities will bring down the interest rates on these securities. The lower interest rates on longer-maturity securities will then induce the nonbank private sector to borrow and spend more. Also, the lower interest rates on longer-maturity securities will make equities more attractive investments at the margin, thereby causing a really in equity prices, which, in turn, will induce the private sector to increase its current spending on goods and services via a wealth effect. Fed hopes by purchasing treasury bonds keep the interest rate low, therefore when Option ARMs resets homeowners could take advantage of lower interest rate which theoretically could save many homeowners from defaulting on their mortgages.
What's wrong with QE2?
1) Liquidity traps: "After interest rate has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control." - John Maynard Keynes, The General Theory.
2) Lowering interest rates hurts savers, retirees, and even small-town banks that cannot access the monetary pumping from the Fed and must rely on their depositors. The Fed argument on helping home owners won’t be as easy as it sounds, because when home owners are 30-40% under water they cannot refinance; therefore low interest rate would not do any good. It makes more sense to use strategic default instead of continuing paying mortgage of a house that its value has fallen sharply.
3)Hyper inflation and dollar devaluation. Printing so much money would cause the dollar loses its value and ultimately we could have a very high inflation in the US. We are privileged to print a piece of paper and call it dollar and export it to the rest of world to import goods. What could happen to our economy if Bernake cause the dollar to loose its status as world reserve currency? What could be the side effects of money printing policies? The rest of the world does not need this extra liquidity, and this is where the second problem emerges. Several emerging economies, such as Brazil and China, are already close to overheating; and the euro zone and Japan can ill afford further appreciation in their currencies.
In my opinion quantitative easing(QE2) is just a different way to inject money into insolvent financial institutions. It would be a political suicide to tell to American taxpayers that they want to bailout insolvent banks once again therefore they are going to use QE2 as a cover up. Bernake wants to help Zombie banks by buying Treasury bonds. In last couple months banks has bought huge sums of treasury bonds, and they will be the sellers to Fed. So when Fed buys bond financial institutions are going to pocket the money. Bernanke argues that QE2 could cause the wealth effect, it means when the stocks value increase people should feel wealthy therefore there is a chance they are going to spend more, and spending more would jump start the economy. I don't buy his argument because stock market rallied about 80% since March 2009 but there is no wealth effect so far! What is the guaranty we get it this time? If he is right why Japan central bank could not get any wealth effect after a decade of quantitative easing?