QE2 = Printing Money

Just as gay no longer means happy, QE2 no longer means Queen Elizabeth II.  Lately, the business world has been using the term QE2 a lot.  QE2 is short for the second round of the United States Federal Reserve’s (“Fed”) Quantitative Easing (“QE”).  This second round of QE is estimated to total $600 billion.  The first QE which was spaced out over one year, between 2008 and 2009 totaled almost $2 trillion.

Bloomberg News reports that the average person does not understand the function of the Federal Reserve.  Therefore, it is easy to conclude that QE is even less understood by the average person.  It is my goal to unravel the mystery of QE in this article.  To simplify, QE is another term for “printing money”.  The Fed, which is the Central Bank of the United States, regulates the amount of money in the economy by selling and buying bonds and by increasing and decreasing interest rates to member banks. The Fed has several ways of printing money.  It can issue Treasuries, i.e. notes, bills and bonds and it can also just credit itself as in this case of Quantitative Easing.  The Fed simply credited its balance sheet for the amount it needs to buy bonds from banks and other financial institutions.  The assets the Fed will buy with the money it credited itself are not limited to government bonds but are expanded to include mortgage backed securities and corporate bonds.  The Fed’s objective is to stimulate the economy by encouraging lending.  Reducing interest rates to almost nil has not worked to stimulate lending so this is the last resort for the Fed.  When the Fed buys idle assets such as treasury and corporate bonds, the banks and financial institutions such as Goldman Sachs receive liquid assets on their balance sheets in exchange for idle assets thus increasing the amount of cash at their disposal.  The Fed is hoping that the banks would ease up on lending and lend this new found cash to businesses and individuals. The assumption is that businesses that can borrow would use the money to increase capital investments, expand operations and hire more workers. For the banks to profit on QE, the newly found cash will have to be invested somewhere, i.e. by lending it to credit worthy borrowers or by putting the money in other investments such as into the stock market.  This is the main reason of the sudden surge in equity prices at Bernanke’s announcement of QE2. The Dow Jones Industrial Averages (DJIA) increased by 11% since August in anticipation of the announcement which happened in early November.

QE2, a.k.a. “printing money”, a.k.a. “expansion of the money supply” will reduce the value of the dollar.  This is basic Economics; The Law of Supply and Demand.  The dollar has been losing value against major currencies since the announcement of QE2.  Increasing the money supply will also increase inflation.  The word “inflation” is just as mysterious to most people as any economics term although it is one of the most overused words today.  To simplify what it means, imagine you are 1 of the 5 remaining finalists on the CBS show SURVIVOR.  You have not eaten any solid food in 5 days.  Jeff Probst, the host brings out a slice of pizza and gives each person $100.  He asks the players to bid an amount for the slice of pizza and the highest bidder wins.  Since there is only one slice, it is safe to say that each player would scramble to bid $100 for that single slice even though that slice normally costs only $2 in any fast food court, because once that slice of pizza is gone, it’s gone.  What if there are 6 or 7 slices?  What if there are 20 slices?  Then the bidders will not have to bid so much because there are more than enough slices to go around. Everyone can get a slice even with a low ball offer.  Let us get back to the single slice example but add quantitative easing to the scenario.  5 players have $100 each to buy up a single slice of pizza but you just happen to have a checkbook in your back pocket.  Every player bids $100 but you hand over $100 cash and a $100 check.  You get the slice of pizza.  That my friends is how QE works.  With your checkbook in hand, you are the Fed.

The Fed is hoping to stimulate the sluggish economy with its QE2 move but many economists think that the move may only spur inflation, not the growth needed to reduce the high rate of unemployment.  Officials of other countries including China, Brazil and the EU were quick to criticize Bernanke’s move arguing that QE2 only serves to promote currency wars.  After all, Japan’s decade long QE did not work, why should it work here? A cheap dollar is not good for foreign exporters of goods into the United States because their products become more expensive for Americans which causes higher inflation.  I am of the opinion that QE2 is not a good idea.  QE1 was necessary to restore stability to the banking system but I find this second round of QE as an arrogant and a largely political move.  Arrogant because Fed’s Chairman Bernanke knows that the dollar is the global reserve currency so the printing of money can be done without bankrupting the dollar.  Political because President Obama’s popularity will keep plunging unless the 9.6% unemployment rate is reduced.  The Fed’s QE2 move seems to be calculated to substantially reduce unemployment before the next presidential campaign goes into full swing.

Finally for investors, be cautious.  If you are invested in the stock market, watch the market carefully.  This newly printed money will be looking for a home.  Some of it will inevitably find its way into the stock market driving equity prices up.  The “feel good  effect” of seeing your investment or retirement account go up in value may indeed spur an increase in your consumption pattern contributing to the growth in GDP but this “feel good effect” is not a long term condition.  This intervention in an economy that is slowly but surely on the way to recovery is unjustified.  It may lead to the next bubble burst.

This article is not intended to provide financial advice.  Please consult your financial advisor before acting on any advice provided herein.

Any opinions and views expressed herein are the sole responsibility of the writer.

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