Today the Federal Reserve announced another round of Treasury bond buying to stimulate the economy…to the tune of $600 billion.

Bernanke and company have telegraphed this move for weeks. So much so the financial news networks have coined the term “QE2″ a moniker once relegated to referring to a British ocean liner now stands for “Quantitative Easing 2″…as in round 2 of pumping money into the system.

QE2 Comes To Fruition

We know now what QE2 will entail. Here’s how it looks…

The Fed will buy approximately $75 billion of long term Treasury bonds per month for about the next 8 months. In addition, they will reinvest about $250-$300 billion in the mortgage-back securities market. They will be constantly monitoring the effects and adjust as needed.

If you don’t understand the goals or the process the Fed is undertaking with QE2…maybe this will help.

Quantitative Easing Defined

I found a number of interesting definitions of “quantitative easing” but the one from Wikipedia looks right on target. It says:

“A central bank implements quantitative easing by first crediting its own account with money it creates ex nihilo (“out of nothing”).[1] It then purchases financial assets, including government bonds, agency debt, mortgage-backed securities and corporate bonds, from banks and other financial institutions in a process referred to as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money, and thus hopefully induce a stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.”

This definition needs a little fine tuning. First, you must know quantitative easing is thought of as the “last knife in the drawer” in that it is only used when other methods of monetary policy have failed.

So right there, you get the picture, the Fed is running out of tools to stimulate the economy.

Next, we must understand things can go wrong with “the process of deposit multiplication from increased lending the fractional reserve banking system”.

The theory is that once the banking system is flush with cash from the Fed purchases, they will lend out this money to you, me, and small businesses (“increased lending” in our definition). The folks borrowing the money deposit the borrowed funds into their account.

Once you, me, and small businesses have the money in our account, the theory says we will spend it. So, if I buy a car with a car loan, I deposit the $30,000 loan proceeds in my bank. I then pay the car company my $30,000 and they deposit it in their account.

Now, they have my $30,000 of which some is profit, so maybe if 10,000 more folks do what I did, they will need to hire more workers as demand for their cars is on the rise. Newly hired workers get paychecks which they deposit in their bank acounts…this completes “the process of deposit multiplication” in our definition.

Of course, this works through out every sector of the economy simultaneously, not just in the car market. Credit cards feed consumer purchases of clothes, groceries, and concert tickets. Mortgages feed the housing market. When QE works to lower rates, it is supposed to lower rates across the board, so all forms of borrowing comes cheaper…and therefore stimulative.

So that’s how the theory is supposed to work…but could anything go wrong?

You bet!

Quantitative Easing Theory Has Holes

As you can see above, there are at least three holes in QE theory.

1. This theory depends on the banking system to lend money to everyday people.
2. This theory depends on those everyday people are willing to borrow and spend the money.
3. This theory depends on rates coming down across the board to have the greatest impact on all sectors of the economy.

These are real problems for the following reasons:

1. The mood in the country with a 9.6% unemployment rate is such right now that folks are in saving and paying down debt (aka…”de-leveraging”) mode…not borrowing and spending mode.

2. The banks have shown in the recent past that they’d rather hold on to their reserves in this unpredictable economy than lend it out to everyday people.

3. The banks have shown no interest in taking rates on credit cards lower, so this QE2 will miss a huge segment of the economy. It is possible that only mortgages could see a rate reduction that even has a chance at being stimulative. The problem there is the housing market is not a market most Americans have much faith in right now, so how stimulative could lower mortgage rates really be?

This just goes to show how little power the Fed and the Government has to effect the economy in a meaningful way. Like it or not, time is the only real cure for Depressions or big Recessions. Consumers have to get back to consuming on their own. They need to rid themselves of debt so they can feel good about consuming again. They need to feel safe in their employment. Companies and consumers take time to de-leverage.

The good news is both companies, local governments, and consumers have been de-leveraging for a couple of years now. Soon they will feel confident in their financial stability.

Only then, will consumers, companies, and governments go back to spending…now matter what the Fed does.

So hang in there…it will get better…just slower than we’d like.

Good Luck!

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