Fed Poised to Make Everything More Expensive

This Tuesday and Wednesday, the Fed will unleash a second round of quantitative easing (increasing the money supply) geared at jolting the economy back into action. After failing to keep unemployment at bay and stabilize falling prices, the Fed needs to put the paddles back on the economy’s chest. The Financial Times explains:

The goal of QE2 – the nickname for this new round of easing – is to push down long-term interest rates by buying long-term Treasury bonds. On its success rests both the reputation of Ben Bernanke, the Fed chairman, and the chances that the US economy can avoid a decade of weak growth. At this week’s meeting, on Tuesday and Wednesday, the Fed’s rate-setting open market committee will assess just how badly it expects to miss its dual mandate of maximum employment and stable prices.

Rather than a huge programme of asset purchases all announced up front, the Fed has made clear that it wants QE2 to evolve in size depending on the economic data. But it is still likely to make a downpayment by pledging at least some asset purchases on Wednesday: $500bn is a likely figure for this initial round of buying.

The risk of quantitative easing is hyperinflation. But the Washington Post reports that inflation can basically scare people into stimulating the economy:

The economy isn’t in free fall. But as new data on gross domestic product affirmed Friday, the economy is mired in mediocre growth, too slow to bring down the unemployment rate. Inflation, meanwhile, is running about 1 percent, below the rate Fed officials view as optimal. When inflation is a little higher, it encourages consumers and businesses to spend money before it loses value.

“Phase one was to avoid a complete market meltdown and something akin to the Great Depression,” said Mark Gertler, a New York University economist who has collaborated with Bernanke on academic research. “Phase two begins now and is in some ways trickier. . . . Once again we’re in a situation where we have to use policies we haven’t really experimented with.”

….if the Fed overshoots or falls short, it could undermine the faith of the public and the financial markets in the ability of the government to address prolonged high unemployment and the risk of falling prices.

At a time when investors are already skittish about gridlock in Washington, such doubts could spook financial markets, creating a self-reinforcing downward cycle in the economy.

Zero Hedge writes that the Fed might even be pushing a policy of hyperinflation:

A Fed paper released in September…was “Oil Shocks and the Zero Bound on Nominal Interest Rates“, in which author Martin Bodenstein (an econ Ph.D.) argues that oil price shocks (i.e., surges in the price of oil such as the one we are about to experience courtesy of a fresh trillion in liquidity about to be unleashed by the Fed) are… wait for it… beneficial to GDP and stimulative to the interest-rate sensitive parts of the economy. To wit: “In fact, if the increase in oil prices is gradual, the persistent rise in inflation can cause a GDP expansion.”

Yes you read that right. The Fed is stealthily floating the idea that a surge in oil prices will be for the greater good. In essence, the Fed is telegraphing that while it acknowledges that oil is about to jump to over $100, it won’t be as bad as those with a functioning brain dare to claim.
Read the entire explanation here.

$1,350 bullion isn’t sounding so bad right about now.

  • rjs

    QE II is likely to go into commodities & the markets; it’s unlikely to reach the street level and “make everything more expensive”, no more than QE I did…

  • Drea

    RJS–can you explain to me how it’s unlikely to reach the street level? QE1, tho’ the market seems to think it was a success, didn’t have the desired effects on lending. It did seem to improve bank balance sheets. It seems that QE2’s goal is to increase aggregate demand through inflation. What will actually transpire is anyone’s guess, but I’d like to hear how you think things will play out, and how price increases won’t hit street level.

  • rjs

    Drea, its more my sense of what might happen than an exact scenario; my feeling is that QE will drive a commodities/market bubble and not affect unemployment… let me try to explain…at least as its been described so far, the fed will be buying long term treasuries; in turn, those such as PIMCO who are now in treasuries will move to other markets, possibly into corporate debt or emerging markets…the liquidity eventually works its way into equities and commodities, and to that extent that commodities play into prices you might see some minor increases at the street level….as you mention, it will continue to allow the banks to recapitalize, but its still pushing on a string; just like the first QE, there will still be no incentive for the public or business to borrow when the public is overextended already & businesses are still below capacity…so without accompanying fiscal policy there will be no increase in spending, and no boost to the overall economy…

    krugman has had several posts on the ineffectiveness of QE; here’s one: http://krugman.blogs.nytimes.com/2010/10/23/how-to-think-about-qe2-wonkish/

  • Drea

    Thanks for the explanation & Krugman links. This is going to be interesting (& demoralizing?) to watch.

  • rjs

    Drea, this what you meant when you said “everything”?