I noticed that Patty Hirsch's video of Quantitative Easing has 73,000+ views. Brad and I have had some discussions about QE2 (the second round of Quantitative Easing) and I talked to another economist friend of mine (we'll call him Shawn) who was kind enough to write some thoughts about QE. I have posted below...
The Problem:
The U.S. economy is currently sputtering along, hovering at high unemployment (almost 10%), and facing a possible risk of deflation. Core inflation (which excludes volatile food and energy prices) is currently at .06 percent, the lowest ever on record.
The Fed’s Solution:
The Fed will purchase $600 billion worth of U.S. Treasury bonds (2 year/10 year/30 year bonds) over the following months, adjusting the amount after each set of purchases according to the economic response.
Why?
The Fed’s main goal right now is to invigorate the economy, but its intention is hampered by investors who park their capital in U.S. Treasury bonds instead of investing it in riskier assets like stocks.
To incentivize these players to move their money into stocks, the Fed must reduce the appeal of U.S. Treasury bonds.
Their Plan:
Buy billions of dollars worth of U.S. Treasury bonds → Lowers the U.S. Treasury bonds’ interest rates → Creates less demand for these bonds → Greater possibility for investors to move their money into stocks → Greater stimulation of the economy
The Risks:
RISK #1: Inflation
The Fed purchased these bonds by printing 600 billion dollars. Increasing the money supply runs the risk of higher inflation rates. (Why? A fundamental rule of economics is that the greater the supply of a product, the less its value. The same is true with currency. So the more supply of dollars, the less its value, meaning the more dollars it will take to purchase the same amount of goods, i.e. inflation.)
1. If inflation occurs, consumers will have to pay more dollars to purchase the same amount of goods.
2. Lenders become more restrictive in providing credit. Since fixed-rate loans are not adjusted for inflation, the payments a lender receives from the payee in the future will effectively be worth less and less. For example, if a lender provides credit at a 3% annual interest rate in an environment with 5% rate of inflation, the $500 a lender would receive next year would be worth less than $500 in the present, so why lend at all? If credit tightens, the economy may dip back into recession.
3. Inflation may not be uniform across all sectors. If inflation rates have a greater influence on the prices of oil and other imported commodities, it would be a boon for exporters overseas but, in turn, hurt many U.S. businesses.
Reason to take Risk #1: Greater Cushion
The Fed targets a 2% annual rate of inflation. This number, they believe, is one that reflects that the economy is moving forward at a reasonable pace. In the last eight months, however, the rate of inflation was only barely above 1%. This current low rate of inflation mitigates some of the very real risk of higher inflation.
More Reason(s) to take Risk #1: Inflation Good
1. Stimulates economy today - Just the anticipation of higher rates of inflation in the future drives greater demand today. If people believe that a new couch will be 5% higher next year, they will presumptively take out a loan with say 3% interest and choose to purchase the couch now. (Thought to consider: Do most people really think about this when they make their purchases? This reasoning may be sound in theory, but not in reality.)
2. Good for Borrowers - Makes it easier for consumers to pay off existing debt on fixed-rate loans. Higher inflation typically translates into higher wages. Since fixed-rate loans are not adjusted to the rate of inflation, the rate will stay the same as a consumer’s wages increase. (The opposite is the reason for why deflation is a problem – makes it harder for consumers to pay off fixed-rate loans.)
RISK #2: International Consequences
1. Devaluation Wars
China has been artificially deflating its currency in an effort to run trade surpluses. China pegs its currency to the dollar, ensuring that Chinese goods would be cheaper to purchase no matter how strong or weak the dollar becomes. The U.S. has been critical of China’s currency manipulation as the cause for the U.S. soaring trade deficits.
I think it's important to inform you of Currency Pegs. For this, we'll insert another Patty Hirsch video...
Now China hurls the same argument at the Fed. With an additional $600 billion "printed", the dollar is expected to get weaker, allowing some U.S. goods to be more competitive abroad and, in turn, reducing the trade deficit. Good for the U.S., not good for China.
To remain competitive, other monetary institutions may attempt to manipulate their respective currencies toward devaluation as well. So we may see widespread currency devaluations, leading toward greater instability in the currency markets.
2. Loss of Foreign Purchasers of U.S. Debt
China purchases and holds trillions of dollars of U.S. debt. It wants assurances that the dollar does not devalue too significantly, or else its holdings would devalue significantly as well. Since it was unable to dissuade the Fed from its quantitative easing initiative that may lead to the dollar’s devaluation, China and other foreign purchaser may abstain from further purchases of U.S. debt. If this happens, Treasury markets may suffer, leading to higher interest rates and inflation.
Many thanks to Shawn for his input.
Next up, I will attempt to explain Quantitative Easing and the Phillip's Curve.
Excellent stuff! This would be an awesome textbook!
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